Could escalating trade wars trigger the next recession?

Patrik Schowitz

Patrik Schowitz

It’s easy to blame the current noise and volatility in financial markets on the brewing trade spat between the US and a range of countries, most notably China. 

But scratch a little beneath the surface and there is a bigger underlying worry: the economic cycle is undeniably getting very long in the tooth.

How much longer can it run?

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Most of this discussion in financial markets centres around the US economy.

As maddeningly as this US-centeredness can often feel to investors across the rest of the globe, there’s a good reason for that. Since World War Two, only the US economy has been big and interconnected enough to drag down the world economy with it, when it goes into recession (i.e. shrinks for several quarters).

It has now been almost exactly nine years since the start of this US economic expansion, making it the second-longest on record. And as the saying goes, when the US sneezes, the rest of the world catches a cold.

True, it is quite likely that the Chinese economy is now also big enough to have that clout, but since we have not yet seen a real recession in China, no-one can know for sure.

Of course, the worries about trade and recession are linked.

As it gets later in its cycle, an economy becomes more vulnerable to damaging events.

As interest rates rise and business and consumers increasingly get stretched, the economy runs out of shock absorbers. And an escalating trade war could conceivably be just such a shock.

Although, in order to tip the US and global economy into recession, current tensions would have to grow into something much bigger than currently looks likely. Growth is still far too robust for that.

All of this matters to investors since - with only very few exceptions - global bear markets in equities (usually roughly defined as drops of more than 20 per cent) are caused by economic recessions and, conversely, a recession is inevitably accompanied by a downturn in equities.

So when it gets ‘late’ in the cycle it is sensible for investors to be increasingly on the lookout for signs of an imminent economic downturn so they can reduce risk in their portfolios in good time.

However, there is also an opportunity cost to cashing out of equities too early that has to be weighed against the benefits of staying invested.

Historically, equity market gains in the last year before a bear market starts have been very significant.

Over the last 50 years in the US, these last-year returns have often been in excess of 20 per cent and never less than 10 per cent. And when equity markets do peak at the beginning of a new bear market, they very rarely collapse overnight.

Instead, at first they usually decline fairly gradually for a few months. In other words, there is usually time to get out and there is no need to time the market perfectly.