Why Trade War Escalations Are More Dangerous for U.S. Now Than Earlier

The U.S. and China exchanged fresh blows late last week in their escalating trade war that has been weighing on global economic growth. But the latest round of tit-for-tat tariffs is likely to be much more damaging to the U.S. economy than earlier rounds. The impact of those increased tariffs could send already-tepid global growth dangerously close to recession levels, creating a significant drag on the U.S. economy, according to Morgan Stanley.

“[W]e believe that it is likely that the U.S. will now face a greater impact than it did in the earlier rounds of escalation,” wrote Morgan Stanley’s analysts in their most recent Global Macro Briefing report. “Amid abating tailwinds, the impact of the global slowdown is now more prominently spilling over to the U.S. economy.”

What It Means for Investors

On Friday, China announced that it would be implementing additional tariffs of 5-10% on $75 billion worth of U.S. goods. U.S. President Donald Trump retaliated, announcing an increase of tariffs from 10% to 15% on $300 billion worth of Chinese goods set to come into effect on September 1 and December 15, and an increase on already existing tariffs from 25% to 30%, which will take effect on October 1. Needless to say, negotiations appear to have regressed.

The ramping up of tariffs will only exert more downward pressure on an already weak global economy. Global real GDP growth has fallen to a six-year low of just 3.0% year-over-year, dragged down by lagging corporate confidence, slowing capital expenditures and the lowest trade volume in nearly seven years. Global manufacturing PMI, having contracted for the second consecutive month, is also at a 7-year low.

Supposing the recently announced round of tariffs comes into effect according to schedule, Morgan Stanley predicts global growth to weaken more than previously expected. Year-over-year growth for the first quarter of 2020 is now projected to be 2.6% as opposed to the earlier estimate of 2.8%. For the four quarters ending by the second quarter of 2020, growth is expected to average approximately 2.7%, just 20 bps above the global recession threshold of 2.5%. 

"If the U.S. raises tariffs on all imports from China to 25% and China makes a matching response with these measures staying in place for 4-6 months, we believe that the global economy will be in recession in 6-9 months," said the report.

Amid weaker global growth, the U.S. economy is expected to feel the effects of the escalating trade war more intensely than it has up until this point. Even while trade tensions escalated during the second half of 2018, the U.S. economy received a stimulus from Trump’s corporate-profitability and consumer-income boosting tax cuts. But that effect is fading and new rounds of stimulus don’t come into effect till later this year and are expected to be much smaller in size. 

The U.S. labor market, which up until now has exhibited relative strength, is starting to show signs of stress as the already slow growth in the manufacturing and trade-related sectors begins to spillover into overall business sentiment and investment. Payroll additions in July slowed to 141,000 on a six-month moving average basis, down from 234,000 at the start of the year. Growth in aggregate hours worked slowed to 0.7% year-over-year in July from 2.8% in January 2019. Layoffs may be just around the corner.

If weakness in the labor market persists, it could soon lead to falling incomes and less consumer spending. The consumer has been one of bright spots in the U.S. economy, but sentiment fell in August on the announcement of more tariffs and stock market volatility. Despite a recent interest rate cut by the Federal Reserve and expectations of further monetary easing, a full recovery is unlikely as long as trade uncertainty continues and tariffs remain in place. 

Looking Ahead

Morgan Stanley concludes that risks of further escalation remain skewed to the downside and that further rounds of increased tariffs would most likely plunge the global economy into a recession. With each side not wanting to back down, it may take further weakening of global growth before the economic pain forces a softening of hardened wills and a subsequent resolution.