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The bear case: Trade 'Cold War' makes recession more likely

➤ A "Cold War II" between the U.S. and China is contributing to recession risks, along with manufacturing recessions and weakness in the eurozone, U.S. and China.

➤ Monetary and fiscal policy can be used to delay or diminish the effects of a recession without preventing one.

➤ Policy responses to a recession are likely to be more constrained than during the Great Recession due to higher deficits and looser monetary policy.

As trade wars drag on, consumer confidence is shaky and some international economies showing signs of contraction, U.S. recession fears are on the rise after nearly 10 years of growth. In August, nearly three-quarters of business economists predicted a U.S. recession in 2020 or 2021. S&P Global Market Intelligence talked to Brunello Rosa of the analysis firm Rosa & Roubini Associates — whose other principal, Nouriel Roubini, is sometimes called "Dr. Doom" — about the risks to growth and the case for a recession. An accompanying interview with Gregory Daco of Oxford Economics offers the case for no recession in the U.S. or globally in the next two years and can be found here.

The following is an edited transcript of the Rosa conversation.

S&P Global Market Intelligence: Why are we headed for a recession in 2020?

Brunello Rosa: There are a number of factors at play, I would say: An ongoing trade war, which has many legs. A tech war, which has also resulted in a currency war, as we saw in the depreciation of the [Chinese] renminbi. The localization of the global supply chain whereby manufacturers around the globe are now starting to use local suppliers as a result of the trade war. All this amounts to what we call Cold War II, between the U.S. and China.

SNL Image

Brunello Rosa, CEO and head of research at Rosa & Roubini Associates.

Source: Brunello Rosa

There are two other important phenomena: One is the ongoing manufacturing recession. That is having a particular impact in countries such as Germany, and it is affecting the entire eurozone. And finally, the other phenomenon is social unrest in important countries such as China and Hong Kong and in Russia.

I would say for a recession to occur requires the three main areas of the global economy — China, the U.S. and the eurozone — to enter stagnation, if not proper recession. Now the U.S. has been doing well for some time, but then this was also tied to fiscal stimulus that was approved by [President Donald Trump], and now the effect of that fiscal stimulus is fading and becoming a fiscal drag. In the meantime, you start seeing effects on the U.S. economy of the trade war that he has waged on China.

Once you have these underlying phenomena that are affecting these three important regions of the global economy, you might conjure to have a severe slowdown, if not a recession, in 2020 or 2021.

Why would it happen in 2020 or 2021?

These things don't happen overnight. It takes time, and it could be 2020 or 2021 — depends on the policy response. To some extent, policymakers are already reacting. What we know for sure is that the policy response this time around is more constrained than it was in 2008 and 2009. Deficits tend to be larger, and especially debt levels are much larger than before. In terms of monetary policy, central bank balance sheets are bloated, and in some cases interest rates are easing or negative.

You wrote in 2018 that there were 10 reasons to expect a recession in 2020, including the possibility that the Federal Reserve could raise rates too quickly. Now that they've taken a more dovish stance, has that changed your outlook?

Instead of eliminating the risk, it's pushing it back, so that's one of the reasons why it might move from 2020 to 2021. The monetary response the Fed has at its disposal might not be enough to counter the effects, for example, of credit wars spiraling out of control. Think about 2008, 2009: In that case, [the Fed had] 500 basis points to play with, and yet the crisis still hit and the economy went into a severe recession. It's not enough just to cut rates to prevent that from happening.

Do you think recent stock market highs and stock market optimism has been unwarranted given risky global economic conditions?

Yes, definitely. New highs have been reached. It has reached new highs because the Fed is cutting rates, growth is still there, and policymakers around the globe are on the dovish side both from the fiscal and monetary perspectives. But then the market is also giving some signals of fatigue with this sideways movement and sudden reversals. Other market signals are out there, including the inversion of the yield curve. If a correction were to occur, it could be even larger than last time. The amount of debt is in fact larger than last time because we solved the debt crisis by issuing more debt, but also finding new buyers, which were central banks. Two, this debt, a lot of it is sovereign debt, but also a lot of it is U.S.-denominated corporate debt from non-U.S. companies that had been issued. Last time around, it was household debt, mortgage debt and so on. This time around might be more on the corporate sector side.

Consumer sentiment and job growth have been bolstering the U.S. economy and contributing to the growth that the U.S. has been seeing, despite businesses' reluctance to invest because of ongoing trade conflicts. Will businesses need to take additional steps to cut costs because of trade wars, like cutting jobs?

The first line of defense is always postponing. If that's not enough, of course, there might be the need to start shedding jobs. This is when then something has gone particularly wrong because when jobs start being shed, the economy is already contracting to some extent.

Are there particular industries or sectors that might be most directly affected?

Manufacturing is affected by two aspects. One is the trade war. The other point is most of this manufacturing would have technological content in there, and once you start forbidding [manufacturers] from purchasing essential parts from some suppliers, all of this tends to impact manufacturing. You start imposing tariffs on agricultural goods, then you start having problems with agriculture: Soybeans, wine, whatever is being discussed. Little by little, those trade wars tend to affect every segment of the economy.

You've said that typical monetary and fiscal policy tools will not be enough to reverse some of these supply shocks and overall economic lag. What can be done on the monetary policy front in the short term?

For these central banks, the first policy response will likely be cutting rates, if you have space. If it's not enough, most central banks have taken to restart their net asset purchases, so increasing again their balance sheets. The Fed will take a little bit longer because they have more space to cut rates, but the Fed has decided at the same time to stop reducing the size of the balance sheet. To some extent, they are also acting on the quantitative side, not just on the price of money.

What can be done in the fiscal policy space?

Some jurisdictions have some room to cut taxes, especially payroll taxes, when needed. There is some room in the U.S., as well, but I would say there's one very easy fiscal policy instrument that should be used: Infrastructure investment. When interest rates are so low, and even negative in some parts of the world, that is a no-brainer. Of course these projects take years, sometimes decades we all know that but in that case, there should be time to approve them and launch them.

What can be done to support consumers in the event of a downturn that affects employment?

On the monetary side, a lower rate helps consumer credit. On the fiscal side, if you have fiscal support to aggregate demand including from the consumer, that tends to help. The reality is that those things only work to some extent, and then you need to allow the downturn to run its course. All those fiscal measures can only reduce the impact of the downturn. They cannot generally eliminate the downturn completely.

If U.S. policymakers, both monetary and fiscal, wanted to avoid a recession right now, what could be done at this point to make that happen?

Stopping trade wars, cutting rates and actually suggesting they can be cut more, and then fiscal easing, more spending and less taxes. These things can go quite a long way in preventing the recession from materializing. Just avoiding a recession and landing with a slowdown, which is still better than a recession.

We need to emphasize the role of geopolitical risks this time around that were not present as much last time. Last time was purely economic, banking, housing prices. This time around there are a number of geopolitical and political risks out there that tend to make economic conditions worse. This is what can make also the policy response more complicated.