JAKARTA (TheInsiderStories) – The past month has brought its fair share of good and bad news. The United States (US) Federal Reserve cut interest rates as expected. The US also enacted an additional fiscal stimulus. Earlier, China initiated modest fiscal and monetary stimulus, and more is likely given weak growth and an escalating trade war. And the European Central Bank (ECB) has promised additional monetary easing. Many other central banks around the world have followed suit by lowering interest rates.

Unfortunately, and at the same time, the trade war between China and the US has taken a turn for the worse. President Donald Trump administration has threatened to impose 10 percent tariffs on an additional US$300 billion of Chinese imports, and China has retaliated by banning US agricultural imports and devaluing its currency by a small amount.

If hostilities do not escalate further, then the impact of these new actions will be adverse but small. If this is just the opening round of a much bigger conflict, then all bets are off, and the risks of a recession will have risen sharply.

The second-quarter US real GDP growth was reported at a 2.1 percent annual rate quarter on quarter (q/q) in the US Commerce Department’s initial estimate. This report was in conjunction with annual revisions, which showed a loss of momentum in the second half of 2018. However, large upward revisions to personal income in recent quarters and improved momentum in consumer spending will sustain growth.

In addition, the US Congress passed, and the president signed, the Bipartisan Budget Act of 2019, which lifts spending caps and suspends the debt ceiling, resulting in more fiscal stimulus in the next few years and less fiscal uncertainty. IHS Markit projects full-year real GDP growth of 2.3 percent in 2019 and 2020.

Furthermore, in Europe, the downside risks are intensifying. Both political developments and economic indicators suggest Europe is headed for stormy waters. The rising probability of a “no-deal” Brexit and the prospects of snap elections in Italy and the United Kingdom (UK) have worsened the risk environment for businesses.

The real GDP growth in the eurozone already slowed from a quarterly rate of 0.4 percent q/q in the first quarter to 0.2 percent in the second quarter (with the German economy contracting 0.1 percent). Eurozone real GDP growth is projected to slow from 1.9 percent in 2018 to 1.1 percent this year and 0.9 percent in 2020. IHS Markit expects UK economic growth to slow from 1.4 percent in 2018 to 1.0 percent in 2019 and 0.6 percent next year.

While in Japan near-term upside surprises. Japan’s second-quarter real GDP increased by 0.4 percent q/q (1.8 percent annualized), a stronger performance than expected. Private investment, government spending, and private consumption all posted solid gains. Strength in domestic demand was offset by weakness in foreign trade.

In response to favorable first-half results, IHS Markit has raised our forecast of 2019 economic growth from 0.7 to 1.1 percent. However, considering the increase in the consumption tax from 8 to 10 percent in October, IHS Markit expects real GDP growth to slow to 0.3 percent in 2020.

The downside risks for Japan could be amplified in a currency war. Given the safe-haven status of the Japanese yen, such a war would likely lead to its appreciation, which would damage growth even more.

While in China more pain from tariffs and menace of a currency war. China’s growth was already slowing before the latest round of trade hostilities. The real GDP growth rate of 6.2 percent y/y in the second quarter was the weakest since China began reporting quarterly GDP numbers in 1993.

If the US imposes 10 percent tariffs on another $300 billion of US goods imports from China, IHS Markit estimates the direct impact would be a reduction in China’s real GDP growth of about 0.2 percentage point in 2020 and 2021.

Anticipating that China would partially offset the adverse impact of new tariffs with additional policy stimulus, IHS Markit forecast of real GDP growth is revised down 0.1 percentage point in the next two years, to 5.8 percent in 2020 and 5.7 percent in 2021.

The 5 August currency devaluation was relatively small and meant as a warning shot, as the Chinese government quickly assured global markets it was not the beginning of “competitive devaluation.” Nevertheless, further devaluation could trigger massive capital flight and financial instability.

Meanwhile, other large emerging markets at the mercy of the US and China. Even in the best of circumstances, emerging markets are sensitive to developments in the world’s two largest economies. Before the start of the trade war, slowing growth in the developed world and changes in monetary policy (initially with a tightening bias, since reversed) affected commodity prices, exports, currencies, and interest rates.

The trade war has intensified these trends by disrupting global supply chains (especially in Asia), pushing down commodity prices, and pummeling exports. On the positive side, the Fed interest rate cut in July and expected ECB stimulus allow central banks in the emerging world to ease their monetary policies. China’s devaluation, if contained, may also be good news, allowing emerging-market currencies to drift down without collapsing.

IHS Markit sees the truce between the US and China (in the wake of the G20 meeting in late June in Osaka, Japan) was short-lived. The new salvo by the White House and retaliation by China increase the dangers of a much bigger conflict and a recession in the near future.

Written by Lexy Nantu, Email: lexy@theinsiderstories.com