The China-U.S. trade war escalates. Could a recession follow?

On the latest edition of Market Week in Review, Senior Investment Strategist Paul Eitelman and Rob Cittadini, senior director, U.S. institutional, discussed the escalating China-U.S. trade war and potential impacts to markets and economies.

Bond yields plummet as trade war between China and U.S. intensifies

U.S. President Donald Trump’s Aug. 1 threat to impose 10% tariffs on the final $300 billion of Chinese imports drew a swift response from China, which devalued its exchange rate and halted all agricultural purchases from the U.S. The retaliatory measures quickly sent markets into a tailspin, with both the S&P 500® Index and the Dow Jones Industrial Average logging their steepest losses of the year on Aug. 5. At one point that day, the S&P 500 was off nearly 3%, Eitelman noted, as markets sold off sharply on the news.

“China’s response to the U.S. tariff threat appears to have been aimed at agitating President Trump,” Eitelman remarked, “as he’s complained for some time about Chinese currency manipulation.” In addition, Chinese President Xi Jinping had appeared to commit to buying more U.S. agricultural goods during a meeting with Trump at the G-20 summit in June, he said. The fact that China abruptly stopped these purchases is quite significant, Eitelman noted, as this was precisely the concession the U.S. believed it had extracted from China.

The poor reaction in equity markets sparked a significant flight to safety in government bonds, with the yield on the benchmark 10-year U.S. Treasury note dropping to approximately 1.7% as of mid-morning Pacific time on Aug. 9. “This is very low from a historical perspective,” Eitelman observed, adding that the drop in yields has been even more significant in Germany, where 10-year government bonds are trading at approximately -60 basis points.

All in all, the trade battle between the U.S. and China has significantly escalated, Eitelman said, sharply increasing uncertainty for the corporate sector heading into the fall.

Could the trade war trigger a recession?

More downside risks have crept into Eitelman and the team of Russell Investments strategists’ market outlook, particularly due to the likely impacts to the global manufacturing sector. “There’s been a gradual deceleration in manufacturing activity since the end of 2017, as this sector is very exposed to tariffs and supply-chain disruptions,” he explained. The trade stalemate between the U.S. and China, which has hung over the industry since the spring of 2018, has led to a marked slowdown in growth rates, Eitelman noted—to the point where some parts of the sector may already be contracting.

“With trade tensions back at a boil again, the manufacturing cycle is likely to continue slowing—and that has ramifications for corporate earnings as well,” he said, explaining that the S&P 500® Index is a representation of many large multi-national businesses with global exposure. Earnings growth rates through the first half of 2019 have already been weak, Eitelman remarked, adding that a mild earnings recession may continue into the second half of the year.

The net effect of all this? More fragility in the U.S., he said, as business executives wrestle with how to respond to heightened uncertainty and the slowdown in growth. If leaders respond by cutting back on hiring, a fairly negative outcome for the U.S. is possible, Eitelman said. “The trade war is a critical watch point right now,” he stated, “and if the situation unravels, I don’t think it would be unrealistic to expect a recession.” Eitelman noted, however, that the more positive scenario of a trade deal between the U.S. and China remains in play. In this instance, business uncertainty would fade and markets would rally, he said.

Key watch points: Future trade negotiations and potential for Huawei waivers

For the short-term health of markets, it’s important that trade negotiations between the two countries continue next month, Eitelman said—and that the additional tariffs threatened by the U.S. on Chinese imports don’t go into effect come Sept. 1. Another crucial watch point is the U.S. approach to blacklisting Chinese telecom giant Huawei, he said. “If the U.S. gives out new waivers to companies who want to do business with Huawei, this could be seen as an olive branch that may incentivize China to start buying agricultural products again,” Eitelman remarked.

Last but not least, markets will get a first read on August manufacturing activity levels in the days ahead, he said. “These numbers will be even more important than usual, in light of all the recent developments around trade,” Eitelman concluded.

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