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US: Turbulence ahead

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  • While the US economy is in a mechanical rebound from the lockdown, several headwinds are converging to pose a threat to the recovery in Q4
  • The pace of the recovery is already slowing as households and businesses are struggling with the impact of the lockdown and the virus
  • Although it seems that the first wave of the coronavirus in the US has peaked, the level of infections remains elevated. This has raised the risk of a second wave in Q4
  • The extension of the fiscal stimulus has yet to arrive, is late, and is likely to be modest. What’s more, a temporary government shutdown cannot be ruled out in October
  • The US elections are likely to lead to increased tensions with China, as opinions about China have become negative among both Republicans and Democrats
  • The US election results are expected to come in slowly in November and are likely to be contested. This will only amplify the ongoing civil unrest
  • Although some headwinds may turn out less severe than others, the US recovery is up for a serious test in Q4 which could cause a temporary setback. The headwinds are likely to cause considerable market turbulence in Q4

Converging headwinds

In April we sketched our expectations for the US economy this year in The Recession of 2020: The Horror Version. We expected a recession in Q1 and Q2, followed by a mechanical rebound in Q3, and finally a temporary setback in Q4. So far the economy has followed our scenario for GDP growth relatively closely. While the US economy is on track for a large growth rate in Q3, several headwinds are converging to pose a threat to the recovery in Q4. This should at least cause a substantial slowdown in the recovery, but we are even pencilling in a modest contraction in Q4. The headwinds will certainly cause considerable market turbulence in Q4.

In addition to the negative impact of the lockdown and the virus on aggregate demand, additional headwinds have emerged. The resurgence in the first wave of the coronavirus means that the US may go into Q4 with an unnecessarily high infection rate. This means that the possible second wave in Q4 would start at a higher level. Meanwhile, the extension of the fiscal stimulus is getting late and may be only modest. The fiscal gridlock also raises the risk of a government shutdown in October. Finally, the US elections were always going to raise the risk of escalating tensions with China, but now it seems the elections themselves may damage economic confidence as they are likely to be contested. These headwinds are converging in Q4 and provide a toxic cocktail for the economy and markets. We take a closer look at the ingredients in the remainder of this special report.

Recovery and the virus

In August, the Bureau of Economic Analysis (BEA) published its second estimate for GDP growth in Q2, which was -31.7% at an annualized rate. This was close to our own forecast of -31.2% published in early April in The Recession of 2020: The Horror Version. Consumption, business investment and residential investment all declined at similar orders of magnitude as GDP. By contrast, federal government spending rose by 17.6%. After -5.0% in Q1, GDP growth in Q2 was going to be the worst with the economy in lockdown in April. Since then, the economy has reopened. However, in addition to the damage to aggregate demand from the lockdown, the resurgence of Covid-19 is dampening the economic recovery in Q3. What’s more, this is still the first wave of the virus outbreak. Health experts are concerned about a possible second wave of Covid-19 that could come as the weather deteriorates and would coincide with the influenza season. While social distancing and using personal protective equipment may reduce both the transmission of the coronavirus and the flu, as we are currently seeing in various countries in the Southern Hemisphere, the failure to contain the first wave of the coronavirus in the US has raised our concerns for the second wave. What’s more, with infection rates still elevated, a second wave would start from a higher level. Given the non-linearity in outbreaks, this could make a second wave even worse.

Figure 1: Daily change in confirmed cases of COVID-19 (1 wk MA)
Figure 1: Daily change in confirmed cases of COVID-19 (1 wk MA)Source: ECDC, Macrobond

Fiscal cliffhanger

In March, the outbreak of Covid-19 and its impact on the economy scared Congress into cooperation. Avoiding the usual lengthy negotiations that the economy could not afford, the CARES Act basically added up a Democratic and a Republican bill, which also explains its enormous size (estimated at $2.2 trillion at the time). The fiscal package supported households and businesses during the sharpest recession on record and during the recovery after the lockdown. For more details about the CARES Act we refer to Trillions.

However, various programs have expired and a new fiscal package is needed. In contrast to March, this time around the two parties find it more difficult to reach a compromise. Even splitting the difference between Democratic and Republican proposals appears difficult. While the Republicans are expressing concerns about the size of the budget deficit, the intended purposes of spending are more likely to be the real problem. The key points of contention – and the reasons why the sizes of the proposals are so different – are the additional pandemic unemployment benefits of $600 per week and the funding for state and local governments. The Republicans don’t want to spend trillions on pandemic unemployment benefits that would in some cases be a disincentive to find a job because that would actually reduce income. What’s more, they don’t want to solve the financial problems of states and local governments that are run by Democrats. So the negotiations collapsed in early August.

Then on August 8, President Trump signed an executive order to add $300 per week to state unemployment benefits, partially extending the pandemic benefits. He also signed three presidential memoranda: to defer Social Security taxes through December 31, to defer student loan payments and interest through December 31, and to identify and review existing authorities to assist renters and homeowners. However, it could still take weeks for the money to arrive in the pockets of the unemployed and then it is likely to run out within 6 weeks. Ironically, while it only partially and temporarily offsets this part of the fiscal cliff, it also reduces the urgency for negotiators to come to a deal. As the adverse impact of the expiration of fiscal support programs is not yet clearly visible in the economic data, there is no sense of urgency on Capitol Hill to compromise on a deal. However, in the coming weeks we could see a deterioration in the data that could create a renewed sense of urgency.

The troublesome negotiations on the fiscal stimulus extension do not inspire much confidence on a spending bill for fiscal year 2021, which starts on October 1. Instead, reports are that Pelosi and Mnuchin have reached an agreement on a clean continuing resolution. At least this would prevent a federal government shutdown. However, a collapse of this deal cannot be ruled out if gridlock on the stimulus package continues. Fortunately, the debt ceiling won’t come into play until next year (August 1, 2021).

Going into the elections without a new fiscal stimulus package while economic data are deteriorating would be a big risk for both Democrats and Republicans, so we are likely to see a modest deal before that. But we may have to wait for economic data to deteriorate to move both sides into action. The extension of fiscal stimulus may become even more important in Q4 as the funds from Trump’s executive order on unemployment benefits will run out. But even if a new fiscal stimulus package passes Congress, it will be late and modest. So it remains to be seen if it will be enough to sustain the recovery.

Tough on China

As the elections are approaching and President Trump remains behind his Democratic challenger Biden, and criticism of Trump’s handling of the Covid-19 outbreak and the protests against racial injustice is rising, the Trump administration is getting more hostile toward China. Hardly surprising as governments often find a foreign enemy when things at home are not going as planned. What’s more, while the US is heavily polarized on domestic topics, there is a broad consensus that China is a problem. According to the Pew Center, the percentage of survey respondents who say they have an unfavorable opinion of China has risen in the last 15 years from a minority to a majority. And – as we pointed out in the August Monthly Outlook – this is true of Democrats and Republicans, even though Republicans always score higher than Democrats on this topic. Nevertheless, in the most recent survey in June 2020, 68% of Democrats and 83% of Republicans indicated having an unfavorable opinion of China. In the inaugural survey in 2005 this was only 34% and 39%, respectively (see Figure 2).

Figure 2: Negative opinions of China
Figure 2: Negative opinions of ChinaSource: Pew Research Center, Survey June 16-July 14, 2020

 This explains why Trump and Biden are trying to show who is the toughest on China. We addressed Biden’s agenda on China in the June Monthly Outlook and concluded that the tensions between China and the US would not disappear with a Biden presidency in 2021. After decades of being naive and complacent about China, Americans are finally seeing that they are up against a formidable adversary that is not playing by US rules.

The ‘rigged elections’ of 2020

The peaceful transfer of power after elections is a crucial test for any democracy, especially for a heavily polarized society. Therefore it is important that the leaders of the competing factions show restraint against each other and respect for the outcome of the electoral process. However, in an interview with Fox News, broadcast on July 19, President Trump refused to say if he would accept the result if Biden won in November. In fact, he has been claiming that mail-in ballots are rigged for months. What’s more, on July 30 –the same day that the BEA published the biggest decline in US GDP on record– he tweeted that the elections should be delayed because “with universal mail-in voting … 2020 will be the most inaccurate & fraudulent election in history.” While Republicans pushed back against Trump’s suggestion, the President is undermining the legitimacy of the election outcome.

What’s more, the US election results are expected to come in slowly in November. In terms of the outcome, we are looking at election week(s) rather than an Election Day.  Since the outcome is likely to be contested, the uncertainty may last even longer. This will only amplify the ongoing civil unrest.

With polarized electorates that believe in their own narratives this perception of the 2020 elections may get hold of a substantial segment of the US population. This then hurts the perceived legitimacy of the elections and the US President that will be inaugurated on January 20, 2021. Meanwhile, foreign adversaries such as the Russians, Chinese and Iranians, are likely to amplify the mutual distrust through cyber warfare. As we concluded in Civil unrest, no matter who wins the elections, the turbulence in US politics and society is not likely to pass. In fact, what we are seeing now may be only the beginning.

Toxic cocktail

A second wave of Covid-19, contested elections, civil unrest and escalating tensions with China could provide a toxic cocktail for the final quarter of the year. Meanwhile, the next fiscal stimulus is late and may be too modest. All of this at a time that businesses are finding out whether they can survive in the reopened economy and aggregate demand has been severely damaged. This explains our expectation of another economic contraction –or at least a substantial slowdown– in Q4.

A second wave of Covid-19 would undermine the recovery. The failure to get the first wave of Covid-19 under control is a failure of US institutions, as we argued in our special report Civil unrest. Protests in the streets reveal a polarized society and a lack of trust in institutions that predates the outbreak of the virus. The elections in November are putting the country under additional stress, both at home and abroad. President Trump has already framed the elections as ‘rigged’ and has taken sides in the civil unrest. The ‘Trump troops’ have already been active in a number of cities run by Democratic mayors, and could return at a larger scale for the elections. Meanwhile the geopolitical tensions with China are escalating. No matter who wins the elections, the civil unrest is not likely to pass. Nor are the tensions with China. While America is polarized on domestic politics, it is increasingly unified in its suspicion of China. Contested elections combined with civil unrest and increasing political violence could deal a serious blow to economic confidence. This could be amplified by escalating tensions with China.

In fact, we expect this toxic cocktail in Q4 to cause a temporary setback in the recovery, leading to -0.8% GDP growth (quarter-on-quarter, at an annualized rate) in the final quarter of the year. So our baseline scenario is a modest contraction in Q4 (a W-shape in the level of GDP), but we expect at least a substantial slowdown in Q4 (a W-shape in GDP growth). A significant setback in the economic recovery would force the Fed to rethink its monetary policy stance. This could even force the Fed beyond forward guidance. Given the Fed’s aversion to negative rates, the next logical step would be yield curve control. For the economy, financial markets and society as a whole we should expect turbulence ahead.

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Author(s)
Philip Marey
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 71 21437

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