Global recession: Here are clues it could be closer than you think

By Chetan Ahya

It may not feel like it, but this global expansion cycle is in its 10th year in 2019. Over the past decade, the global cycle has weathered a number of ‘cycle-threatening’ events, including the debt ceiling issue in the US and the European sovereign debt crisis in 2011, the taper tantrum in 2013, the sharp fall in commodity prices in 2014 and China’s slowdown in 2015. True, global growth has been subpar until the synchronous recovery took hold from 2017 to H12018. But we have been lucky enough to avoid dipping back into recession.

With the recent re-emergence of trade tensions, can the global cycle continue to avoid recession? It is predicated on how severe the measures get, and how long these trade tensions last. If trade tensions continue to escalate, with the US imposing 25% tariffs on the remaining $300 billion-odd worth of imports from China, and China responding with countermeasures, we could end up in a recession in three quarters.

Investors seem to disagree with this alarmist prognosis. They generally hold the view that the trade dispute could drag on for longer, but appear to be relatively sanguine about its potential impact on the global macro outlook. Concerns on the impact of trade tensions stem from three points:

Pervasive transmission channels: Five channels will transmit trade tensions to global growth. First, implementing the tariffs will increase costs. Companies may not be able to fully pass on higher tariffs, which will erode profitability. Consumers, facing higher prices, may pull back on demand. Second, the tariffs’ impact will spill over into the domestic and global supply chains and, consequently, global trade flows. Third, over the medium term, multinational companies will incur additional costs as they develop alternative supply sources. Fourth, global corporate confidence will take a hit, and companies will pull back on capex, which will weigh on aggregate global demand. The indirect impact on financial conditions, corporate confidence and capex would transmit to global growth in a far more severe manner than the direct tariff impact and its spillover effects on the supply chain. Finally, corporates with global footprints will face additional downward pressure on growth and profitability from their international operations. While the first three channels are probably well understood, the latter two channels, which actually have a greater impact, seem under-appreciated.

Non-linear impact: As tariffs rise, the impact will be non-linear. In the first round, when 10% tariffs were imposed, the corporate sector had greater capacity to absorb them. However, if they rise to 25% and include all imports from China, corporates’ ability to absorb them will diminish, likely resulting in higher pass-throughs with more knockon effects.

In addition, as earnings growth slows and uncertainty and costs rise, the leveraged corporate sector will face tightening financial conditions, creating a negative feedback loop. Given higher corporate leverage, this will probably be most pronounced in the US, particularly for companies with weaker balance sheets. Against this backdrop, defaults could accelerate, bringing corporate credit risks to the fore.

Reactive policy response, with lagged effects: Investors are right to expect a stronger policy response in the event of continuing escalation. The US Fed will respond, and China has the willingness and ability to ease both fiscal and monetary policy further to mitigate the impact on the labour market.

However, the reality is that such policy easing will only be reactive. Given that the downside risks to growth are due to trade tensions, policymakers will approach it as being an external risk. So, it will be difficult for policymakers to prejudge the outcome of trade talks and pre-empt it before easing ahead.

Policy easing will, therefore, only be activated after escalation has occurred and its effects on markets and the growth outlook have materialised. What’s more, given the customary lag before policy measures impact real economic activity, a downdraft in global growth appears inevitable should trade tensions continue to escalate.

Trade tensions have re-emerged at a critical moment in the global cycle. Global growth is currently tracking at a subpar rate of 3.2%Y in 1H19 (vs a peak of 4%Y in 1Q18). One expects global growth to stagnate for 2H2019. With trade tensions already having an impact on corporate confidence, the risks to this outlook are skewed to the downside and recession risks are rising.

Against this backdrop, the meeting between the US and China at the G20 summit assumes a heightened level of importance. The outcome is highly uncertain, but the window for resolving trade tensions and avoiding damage to the global cycle is narrowing.

The writer is chief economist and global head of economics, Morgan Stanley