- Trump escalated the global trade war on Thursday by threatening Mexico with a 5% tariff on its goods.
- Although the tariff is designed to hurt Mexico, new research from the St. Louis Federal Reserve shows that the US and Mexican economies are now more interconnected relative to history.
- The research illustrates why a recession in Mexico elevates the risk of a downturn in the US, too.
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Some recession signals in the US are clearly flashing red, including the dreaded inverted yield curve.
But when investors survey the actual economy, the pace of job growth, manufacturing, and other indicators, they're far from the significant decline that would be necessary to confirm a downturn.
What if another reliable indicator of what's in store for the US lies not within its borders, but with its northern and southern neighbors? According to new research from the St. Louis Federal Reserve, investors would be wise to keep a watchful eye on Mexico and Canada's economies.
It's more crucial than ever now that President Donald Trump has escalated the global trade war by threatening Mexico with a 5% tariff on all its goods. In a tweet Thursday, Trump said the tariff is scheduled to kick in on June 10 and will gradually increase "until the illegal immigration problem is remedied."
While designed to hurt the Mexican economy, the tariffs will sting the US, too. The obvious casualties are car manufacturers like GM that source production from Mexico; automakers' shares fell sharply on Friday following Trump's tweet.
But the contagion from Mexico to the US could be even more widespread. According to the St. Louis Fed, Canada, Mexico, and the US have become a lot more economically interconnected since the North American Free Trade Agreement commenced in 1994. In effect, when the trio decided to be more cooperative on trade, their business cycles — especially the downswings — became even more synchronized.
The chart below shows what this has looked like since the 1980s:
"We found that the transmission effects of a recession in the US were amplified after NAFTA," said Michael Owyang, an economist at the Fed.
He continued: "Prior to NAFTA, a shock that increased the probability of a US recession from 10% to 90% raised the probability of recession over the next four quarters in Canada and Mexico by 1.38 and 0.27 percentage points, respectively. After entering into NAFTA, the same increase in the US recession probability raised the probability of recession over the next four quarters in Canada and Mexico by 8.24 and 7.59 percentage points, respectively."
This post-NAFTA interconnectedness is not the only thing that makes the risks of the ongoing trade war unique.
Anyone who has been invested in stocks since early 2018 might already know this. According to Binky Chadha, Deutsche Bank's chief US and global equity strategist, stocks have been range-bound for the last 17 months — and it's only the third time in this bull market that they've been trapped for such an extended period. Indeed the S&P 500 gained just 1.3% from the close on January 1 through Thursday.
What does this have to do with tariffs? Chadha recalled that the stock market's stall began as Trump first slapped tariffs on washing machines and solar panels early last year.
The ongoing trade war was only one factor out of several that kept the stock market range-bound, with Federal Reserve policy being another important one. But if there were ever a single trigger for the next stock-market crash and economic recession, it would be the trade war.
"Despite some worrying signals to start the year, both financial and economic data continue to suggest that near-term recession risks are not yet elevated," said Michelle Meyer, the head of US economics at Bank of America Merrill Lynch, in a recent note.
She added: "However, our model likely does not fully capture the threat of US-China trade tensions spiraling into a more severe trade war, which we view as the biggest downside risk for the US economy."
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