An escalation of the trade war with China, higher inflation leading to a policy mistake, and the withdrawal of fiscal policies are all reasons why the US economic cycle could end in 2020, according to Schroders’ chief economist Keith Wade.
While many believe that a new trade deal will eventually be thrashed out between the US and China, Wade said that the “topic of the moment” is unlikely to dissipate as quickly as some expect.
“Our view is that the US-China ‘trade wars’ are going to last for quite some time and be very prolonged, I don’t suddenly see there being a deal,” he said.
The latest round of tariffs has seen US president Donald Trump administration impose a 10 per cent levy on $200bn of Chinese goods (which could rise to 25 per cent unless a deal is struck).
US tariffs now apply to over $250bn of Chinese goods, which is roughly half the amount the country sells to the US, while China has responded with in-kind tariffs on $110bn worth of American goods.
“A lot of people thought when the first tariffs went off that this was all about the mid-term election and Donald Trump trying to boost his popularity to help the Republicans in these elections,” Wade said.
Final poll approval rating before midterm election
Source: Schroders
Indeed, while the president’s approval rating has fallen dramatically since his election, it has been bumped up more recently.
“I always thought this was a bit of an odd argument because most Republicans believe in free trade – it is actually the Democrats who are always pushing for tariffs,” he said.
As such, this is less of a political stand but something more fundamental – a call to his core demographic of those displaced by globalisation that he is fighting for them.
“There is quite a lot of evidence that the rise of China and globalisation pressures along with other things like automation have really supressed incomes for the middle-income family in the US in a similar way to the UK as well,” Wade explained.
“Those are the people that are looking to Donald Trump for a change and his message that we are going to get tough on China and it is going to be ‘America First’ is very appealing.”
As such, the trade war with China is fundamental to his popularity. In a similar way, however, it is also the same for the Chinese government.
“China faces a very big challenge,” he said. “It is growing a huge amount, it has become a middle-income country but in doing so they have to be aware of something called the ‘middle-income trap’ where you get stuck at that level.
“What China is trying to do is move itself up the value chain from being a cheap supplier of goods to the world economy into being a competitor to the best breed of companies in the world economy today.”
This, however, is a direct challenge to companies from the US, Europe, Japan and elsewhere, which have enjoyed market dominance for some time.
While they are now running out of firepower in terms of what tariffs they can apply, they can still make life more difficult for US companies, he noted.
Wade said: “US companies do business with China not so much through exports but by investing in China, building factories there and selling directly to the people.”
Indeed, General Motors sold more cars in China than it did in the US last year while Apple sells twice as many iPhones in China as it does in the US.
And the country has a track record of making life difficult for businesses, as last year it enforced all the regulations it could on Korean companies following a dispute over a missile defence system that Korea was installing.
Wade noted: “[As such] we could see this continue to escalate. It could be tough, but China is used to that and Xi Jing Ping, unlike Donald Trump, isn’t going to be facing mid-term elections anytime soon.”
Value of Chinese and US exports on other countries
Source: Schroders
The trade war will also likely impact more countries than just China and the US, as the above chart shows.
However, it is just one factor that could cause the end of the cycle in 2020 and is unlikely to be enough on its own.
Typically, he said, it is inflation that ends most cycles, with central banks under pressure to continue with higher interest rates when the situation may not necessarily call for it.
The main area of pressure for inflation is that the US economy is beginning to run out of workers, which means that wage increases are becoming more likely.
While Wade (pictured) believes that the Federal Reserve will raise rates four more times to get to 3 per cent by the middle of next year before stopping, there is a risk that it goes further.
“What tends to happen is when central banks are raising rates it takes time for the tightening policy to have an effect on the economy,” he said.
“Meanwhile, inflation is picking up and people are saying you need to keep raising rates and that is what has caused a recession.”
The third part of the puzzle is the fiscal stimulus that has been pumped into the system by Trump, which should have come to an end by 2020.
“Fiscal policy is great at the moment because the tax cuts are boosting expenditure in the household and corporate sectors and it is adding to growth. But, as we know, the tax cuts will come to an end,” he said.
“We have tried to estimate the impulse of the tax cuts on public spending. This year you are getting about 0.6 [per cent] added by the tax cuts and next year you get about 0.5 [per cent].
Impact of fiscal policies on GDP growth
Source: Schroders
“The tax cut element of that is going to drop away really quickly and that is the really powerful bit,” the chief economist added.
As a result, there will be a fiscal hole that will be largely left unfilled, and this could be quite tricky for the economy to deal with because it will likely lead to a sudden drop in demand.
“That is probably when the cycle is going to end and you will start to see quite a slowdown in 2020 on monetary policy, the end of fiscal policy and the trade wars as well,” Wade said.
“As investors we have got to start thinking about it in 2019 because the market will start to anticipate it about a year ahead of the slowdown. I think the slowdown will be in 2019 with the end of the cycle in 2020.”