U.S. investors are once again paying attention to the dark clouds gathering over the global economy, with reason to fear that the next big storm could be as damaging as the downturn that accompanied the global financial crisis a decade ago.
On a day when the S&P 500 SPX, +0.07% and Dow Jones Industrial Average DJIA, -0.25% were under pressure (though still up sharply from their late December lows), Peter Hooper, chief economist at Deustche Bank Securities issued a research report estimating the damage that may result if the three gravest threats to the global economy come to fruition.
Hooper points to a “significant escalation of trade tensions” between the U.S. and China; a hard Brexit, in which the U.K leaves the European Union with no trade deal in place; and a “sharp slowdown” in Chinese economic growth as the three major macro headwinds facing the global economy today, while arguing that if the worst-case scenarios for all three materialize in the coming months, “the world economy could face a downturn rivaling that which occurred during the great recession a decade ago.”
Read: Here’s how hard China’s slowdown could hit global economic growth
His analysis shows that if U.S.-China trade tensions escalate to the point that it causes a mild U.S. recession, “this outcome will depress global growth by more than a percentage point over the next two years.”
Meanwhile a hard landing in Chinese economy, in which the People’s Bank of China is forced to raise interest rates to fight inflation, remains another possible threat, would reduce growth by up to a percentage point over the next two years.
Finally, “A no-deal Brexit would be highly disruptive to economic activity in Europe,” Hooper wrote. Such an outcome would reduce global growth by about half as much as the above two scenarios. “That said, if this shock should also push Italy into a debt crisis — a serious possibility as well — the negative impact on Europe and the globe could be more than doubled,” he added.
Hooper only places a 5% to 10% chance of any of these scenarios occurring by themselves, meaning that the chance they all occur at once is quite low — less than 1%. Nevertheless, even if the absolute worst-possible outcome is avoided, investors would be wise to remain vigilant against even one of these scenarios spinning out of control.
Matthew Forester, chief investment officer of BNY Mellon’s Lockwood Advisors, told MarketWatch that if U.S. tariffs on hundreds of billions of dollars in Chinese imports are increased on March 1, as they are set to do absent a new trade deal, “the market would react very negatively.”
Thursday’s stumble for U.S. stocks came as White House economic adviser Larry Kudlow said that there was still a long way to go before Washington and Beijing reach a trade deal. Also, CNBC reported that President Donald Trump and Chinese President Xi Jinping were seen as unlikely to meet before March 1, though the report also said tariffs on Chinese goods were now unlikely to be raised to 25% from 10% without an agreement by that date.
“The economic interaction between China and the U.S. is substantial, and larger than any other pair of trade rivals in more than a century,” Hooper said. “It would be challenging to a whole host of industries and supply chains.”
Kevin Divney, senior portfolio manager at Russell Investments, said in an interview that the a hard Brexit could be the macro headwind most likely to catch U.S. investors off-guard.
“That would be a shocking exogenous event, with negative surprises,” he said. “That is the biggest downside risk over the next 30 to 90 days in terms of affecting sentiment,” he said.
Forrester and Divney agreed that the interaction between the Chinese and U.S. economy is the most important variable for global growth and financial markets in the next year. What’s more, it’s incredibly difficult for investors to gauge just what the affect of a serious slowdown in China, or an out-of-control trade war will ultimately be.
“The trade war is unanalyzable because the global economy is so integrated.” Divney said. “There has been a lot of extrapolation, but it’s hard to do, because we just don’t have historical examples to look at,” he added. “I’ve always thought a trade war was inconceivable, because why would you do that to yourself?”
This article was originally published on Feb. 7.
Providing critical information for the U.S. trading day. Subscribe to MarketWatch’s free Need to Know newsletter. Sign up here.