US And Chinese Economies To Face A Very Challenging 2019

In early August 2018, the global economy seems to be in reasonably good shape. Even though global economic momentum is slowing amid trade-related tensions among major economies, yet such tensions have not yet had any marked downside impact on global activity. The US economy is growing strongly and will probably grow annually at just under 3% in 2018, compared to 2.2% (official data) in 2017. Growth in the US will be supported primarily by a strong labour market, elevated consumer confidence, tax and spending cuts (mainly invigorating consumer spending), business investment and benign inflation. Further, the US economy should continue to grow strongly for a few more quarters. The Chinese economy, although slowing, grew at a reasonably impressive rate in the first half of 2018. Given China’s gradual loosening of macroeconomic policy to counter trade-related shocks and a slowing economy, it is likely to be able to achieve the targeted growth rate of around 6.5% in 2018.   

However, in my opinion, there are ominous signs that these two economies are likely to face a rather challenging 2019 (and 2020) - to the detriment of the global economy (and in particular, posing significant downside risks for several emerging economies in Asia). The business cycle in the US may start to turn somewhere towards the end of 2019 or in early 2020 and I expect this economy to grow at a lower rate than 2.4% (CBO forecast) in 2019. Further, Chinese economic growth will possibly decelerate to somewhere around 6% (or slightly above) in 2019. There are a couple of reasons why I believe so - which are stated below - after a brief update on the US and Chinese economies.

US Economy

Given the strength of the US labour market, elevated consumer confidence amid moderate inflation and low-interest rates, the US economy is witnessing strong consumer-led growth (despite moderate wage growth and higher gasoline prices) and reasonably firm business investment too. It grew by an annualized 4.1% (official data) in 2018Q2 - fuelled further by USD 1.5 trillion tax cuts, government spending and temporary factors - such as a surge in soybean exports. However, I believe that growth peaked in this quarter and even though the US economy will  continue to grow strongly for a few quarters (supported by the aforesaid factors), yet the pace of growth will cool increasingly - with the possibility of the business cycle turning somewhere towards the end of 2019 or in early 2020. A recession is also possible in 2020. 

If one looks underneath the impressive growth figures for the second quarter, it reveals that business investment in equipment did not really pick up to the desired extent, despite the tax cuts. It is consumers who actually took advantage of these cuts and spent strongly - consumer spending accounts for around 70% of US GDP. Further, business investment in this quarter grew more slowly, relative to 2008Q1. Moreover, U.S consumer sentiment ebbed in July (even though consumer sentiment is at elevated levels) - University of Michigan’s Consumer Sentiment Index slipped to a six month low in July. This possibly suggests that there might be some cooling of consumer spending in the second half of 2018, as the specter of intensifying trade-related disputes makes consumers less confident and that the acceleration of growth witnessed in the second quarter is unlikely to be sustained in the following two quarters of 2018. 

Turning to business investment again, going forward, there is also a distinct possibility that firms in the US may increasingly, yet gradually, delay or dampen investment/capital spending and hiring plans over the coming quarters (particularly towards the latter half of 2019) - resulting in economic momentum slowing gradually (which will hurt productivity and wage growth in the process). There are several reasons for this.

The reasons are - strong probability of trade frictions intensifying between the US and China in the coming quarters, businesses are reducing leverage (corporate America is heavily over-leveraged), long-term interest rates are at elevated levels - benchmark U.S. 10-year Treasury bond yields spiked past 3% on August 1, 2018 (and yields will rise with continued growth and tighter policy), strength of the US dollar, uncertainty regarding US trade policy and tariffs, business confidence is likely to be adversely affected, global economic activity will probably be more affected in 2019 as a result of escalating trade disputes - hurting profits and exports of companies in the US - and, ongoing monetary tightening by the Federal Reserve (which is likely to have a downside impact on asset values - including lower stock prices - particularly in 2019).       

Turning to consumer spending (the mainstay of the US economy), with productivity and wage growth likely to be affected over the following quarters, as a result of reasons stated above, along with unsustainably low US households’ savings, possibly significantly lower stock prices in 2019 - hurting consumer wealth - strong probability of market turmoil next year, higher tariffs on imported goods (and resultant impact on inflation), expected slower house price growth, higher mortgage rates and lower consumer confidence, consumer spending is likely to grow more slowly in 2019, relative to 2018. 

With reference to trade, with a strong dollar, increased protectionism/trade friction/hiking tariffs on its major trading partners such as China, Canada, Mexico, EU and trading partners in Asia and strong possibility of slower global economic activity, the US is likely to witness increasingly reduced demand for its exports and slower trade over 2019. Finally, the pace of economic expansion will slow as the effect of fiscal stimulus will fade in 2019. 

Trade tensions between the US and China have recently been ratcheted up (the US plans to impose further (and higher) tariffs on additional USD 200 billion of Chinese exports, after having imposed tariffs worth USD 34 billon on Chinese goods. China has also retaliated by imposing tariffs, yet it has been more restrained and is attempting to avoid a trade war). Given that Trump accuses China of unfair trade practices, his emphasis on ‘America First’ policy along with his administration seeking to thwart China’s ‘Made in China 2025’ programme and wanting to substantially lower America’s ballooning trade deficit with China, it is only likely that trade disputes between these two countries will escalate over the coming quarters. 

Next, another important factor that is likely to curtail growth, particularly over 2019, is rising interest rates. Will the current US growth figures and latest inflation data along with the likelihood of gradually firming inflation, the Federal Reserve will probably raise interest rates two more times in the second half of 2018 - September and December (and possibly twice in 2019), in order to prevent inflation from accelerating, keeping inflation expectations in check and to counter the upside effect of elevated oil prices, higher import prices (as a result of higher tariffs) and increased capacity utilization on inflation.

Next, a worrying fact about the US is that its corporate debt is very high (i.e. ratio of corporate debt to GDP is uncomfortably high) as a result of firms having borrowed massive amounts of money at low cost. With rising interest rates and labour costs coupled with the possibility of a slowing economy next year, earnings growth is likely to get dampened. Further, very high corporate debt levels could lead to trouble for the US economy towards the end of 2019 and make firms there more vulnerable before the possible onset of next recession. Moreover, with higher interest rates and debt servicing costs in the coming quarters, several firms could shelve some investments, as they will no longer be financially feasible. All these factors could dampen or delay investment further, in addition to the factors stated above. 

There is a high possibility that a coalition of the aforesaid factors or any one factor could possibly trigger the turning of the business cycle in the US around late 2019 or in early 2020. Its better to be forewarned. 

Chinese Economy

Turning to the Chinese economy, the escalation in trade frictions with the US could not have come at a more inopportune moment, given that it’s economy is slowing. It grew by 6.7% year-on-year (official data) in 2018Q2, compared to 6.8% in the previous quarter - as a result of more aggressive deleveraging that curtailed investment and crimped economic activity. 

While the Chinese economy should grow at the targeted rate of around 6.5% in 2018, yet downward pressures on this economy are clearly rising. This is being reflected in the slide of the Chinese currency, yuan, which has been witnessing continued downward pressure in recent months - unnerving financial markets. It has fallen by around 7% against the USD since April. Unfortunately, this is stoking tensions with the US, who are viewing the slide of the yuan as a deliberate move by China to boost its exports. It is also being viewed as a way by which China is attempting to offset the downside impact of stiff tariffs. 

Contrary to what the US believes, I am rather skeptical about China engaging in competitive devaluation (or that it will let its currency depreciate significantly any further), given the threat of increased capital outflows and related turmoil, Chinese policymakers priority of curbing elevated financial risks and maintaining financial stability, emphasis on ongoing economic transformation, risks posed to China’s overheated real estate market, fear of stoking inflation and limited impact of changes in exchange rate on Chinese exports (though a weaker yuan might offset some of the impact of trade tariffs). Further, given that any further sharp decline of the yuan could adversely impact China’s growth (and result in increased capital outflows), Chinese authorities are very likely to undertake measures to support its currency if need be. However, downward pressure on the yuan will continue, due to rising interest rates in the US, a slowing Chinese economy and a lower trade surplus with the US as a result of imposed tariffs and ongoing trade-related disputes. It might be noted that further marked decline in the yuan could trigger panic selling in emerging market equities and debt. 

Latest data seems to suggest that downward pressures on the Chinese economy are emanating from various sources. There has been a marked slowdown in credit growth (which is starting to filter through to the broader economy and impacting domestic demand growth), fixed investment (which is proxy for infrastructure spending and a key driver of domestic demand) is slowing, industrial production growth has eased, government is cracking down on riskier lending (as China attempts to tackle financial stability concerns), which has raised borrowing costs for firms and consumers, export demand from China’s leading export destinations have slowed, corporate bond defaults are growing, deleveraging efforts continue, household leverage is growing and China’s vital real estate market is cooling (even though the pace is yet moderate), real estate investment growth has softened and retail sales growth has been slower than expected (consumption currently accounts for around 40% of GDP in China).

Although relatively strong consumption and services sector growth, along with a gradual loosening of monetary and fiscal policy, is likely to support growth over the second half of 2018, yet escalating trade tensions with the US and the aforesaid downward pressures are likely to result in a further cooling of the Chinese economy this year. It is already evident that China is shifting to a looser monetary policy - with the PBOC recently (late July) injecting USD 74 billion into the banking system (i.e. $74 billion of Medium-Term Lending Facility credit into the banking system) - holding rates unchanged, in addition to having lowered reserve requirements three times this year. I would expect at least one more reduction in the reserve requirement later this year. Essentially, PBOC is now trying to encourage banks to give more loans to firms - particularly small and medium-sized companies. Fortunately, China has some leeway, when it comes to giving the economy an economic stimulus via government spending and it will probably increase infrastructure spending to support growth in the second half of this year. 

Having stated the above, despite the aforesaid factors that are likely to continue to support Chinese economic growth and prevent growth from nose-diving, the year 2019 - and, particularly from around the latter half of that year (and 2020) - could be rather challenging for China. This is because the full effect of the imposition of tariffs and escalation of trade disputes with the US will in all probability play out increasingly next year (and in 2020). The effect of the same on economic growth could be more pronounced, given that China is increasingly witnessing the unenviable combination of more debt (China’s debt has increased dramatically over the past decade, particularly corporate debt to GDP ratio - which is very high) and slower growth and is also attempting to address financial stability concerns through ongoing structural reforms - which is slowing growth in the short-term. Possibly, the foremost challenge that policymakers in China will face in 2019 (and beyond) is how to simultaneously ensure growth from falling sharply (amid rising trade tensions) while restraining credit growth to a sustainable level, addressing financial instability concerns and handling the serious threat of increased capital outflows. 

Escalation of trade friction with the US will hurt Chinese GDP growth more than the US, given that its exports to the US far exceed imports from the US (according to official data, the US imported USD 506 bn worth of goods from China in 2017, while China imported USD 130 bn worth of goods from the US). Also, the US is China’s second largest export market and the latter has a large trade surplus with the former (i.e. according to official data, the US had a trade deficit with China of $375 billion in 2017 - a record deficit). Further, in addition to lowering demand for Chinese exports, the problem with escalation of trade disputes with the US and more or higher tariff impositions is that it is likely to have more pronounced second-round effects on the Chinese economy in 2019 (and beyond) in terms of significantly dampening business confidence, delaying investment and lowering cross-border investment, which in turn can have serious downside implications for growth. Moreover, rising US protectionism and disputes with its major trading partners are likely to increasingly impact global economic activity over the next year (and 2020), which in turn will probably drag down the profits of Chinese companies and consequently adversely affect private investment activity in China. 

Further, the Chinese economy will probably witness greater deleveraging pressures, more widespread property market slowdown, elevated oil prices, and slower credit growth (as Chinese policymakers attempt to rein in debt) in 2019. If this happens, which it might, then such occurrences are also expected to dampen investment, lower industrial activity and limit business expansion - with major implications for China’s growth momentum and for the global economy too (particular for emerging economies in Asia) in 2019 and beyond. 

With reference to China’s sizable property market, an expected further slowdown next year, as a result of higher borrowing costs, government’s attempts to curb risky borrowing and lower confidence among property investors, will adversely impact China’s GDP directly, lower local government fiscal revenue and result in lower demand from other related sectors such as steel, cement, other industrial sectors and transport services. This, in turn, could lead to a broad based slowdown of economic activity in China next year. 

Having stated the above, China is very likely to witness marked growth deceleration over 2019, relative to 2018. However, given the various factors (monetary, fiscal, strong consumption and services sector growth) that should continue to provide support to growth, I expect the Chinese economy to grow somewhere around 6% (or slightly above) in 2019 and not below this rate.