Recent data from around the world have increased domestic recessions fears. Tariffs and Italy were known risks but this week was complicated further by data that showed that both German and Japanese GDP contracted during the third quarter. Scary stuff; the U.S. must also be headed for recession. Ironically, a Japanese and German slowdown could probably benefit the U.S. by helping to mitigate wage pressures now impacting most industries. A recession remains quite unlikely over the near term.
During the third quarter, Japan’s economy contracted by 1.2%, a major slowdown compared to the 3% growth it experienced during the second quarter. Tariffs played a muted role in the slowdown, since the larger cause came from domestic demand. During the third quarter Japan was crushed by a string of natural disasters, including a couple of very strong typhoons, an earthquake, and extensive flooding. Typhoon Jebi was the strongest storm to hit Japan in 25 years. But as we’ve covered during previous commentaries, the economic impact from these types of natural disasters leads to a short-term hit to GDP that is rapidly recuperated as rebuilding follows. The impact also isn’t typically all that large. The larger explanation is likely far simpler: the prior quarter’s growth rate of 3% was very high, especially for a country whose population is declining. Taken together, the two quarters averaged growth of about 0.9%, a level that is more realistic for its present level of economic growth. We should not take one quarter’s decline in Japan as an indication of imminent Japanese recession. Far more likely is that a series of events coincidentally came together to show a third quarter decline.
Germany also experienced a contracting economy during the third quarter as GDP declined 0.8%. It was Germany’s first decline in over three years. Both exports and household consumption dropped during the quarter. But Germany was impacted by new car pollution standards known as the Worldwide Harmonized Light Vehicle Test Procedure (or thankfully abbreviated as WLTP). The test measures fuel consumption, CO2 emissions, and other pollutants which came into focus following the VW emission scandals. But the test can take up to two days to complete. In order for the tests to be accurate the cars must be warmed to 70 degrees. Also, all variations of a car model must be tested unlike in the past when only one model was necessary. This has created a large bottleneck for auto manufacturers to get vehicles released for sale. This has had an immediate impact on GDP. No cars = no sales.
Nonetheless these bottlenecks are supply driven, not demand driven, and just temporary. Germany will refine and speed up its testing process and will increase the number of facilities implementing the testing. Car sales should recover and GDP should rebound. In fact, as the number of vehicles increases back towards levels demanded, there should be a period of catch up that would benefit GDP.
Germany, unlike the U.S., is heavily dependent on exports. Indeed at over 40% of GDP, Germany’s exports as a percentage of GDP are over three times larger than that of the United States. And the tariffs are having a disruptive impact across the globe, not just in China. The secondary and unanticipated impact of tariffs in one country can have wide ranging impacts on many trading partners. So while the newly minted tariffs create these temporary disruptions, new trading relationships need to be worked out and established. In the meantime there’s a period of friction as sellers and buyers of goods find new relationships, since old ones may no longer make financial sense. With exports as a large share of GDP, these disruptions can have an outsized impact on the German economy, especially in the short run. And any tariffs that target the European auto sector will have an outsized impact on Germany.
For Japan, the headwinds are likely to be temporary and short term, likely lasting a quarter or two. But even if this problem takes a few quarters to resolve it should not have a dramatic impact on U.S. economic growth. For Germany, the issues associated with the WLTP are temporary and will likely work themselves out over the next quarter or two.
Tariff issues may take years to resolve. But the economic impact to Germany for auto tariffs has been estimated to be in the -0.2% range so they aren’t devastating. Currency fluctuations are also helping to mitigate this impact and could entirely offset tariffs. Increased Chinese demand is also helping.
Most significantly, exports aren’t that significant for the U.S. and make up only about 12% of GDP, one of the lowest shares of any country in the world –a fact that itself is worthy of a commentary and suggests some strong evidence about the structured inequity that currently exists between countries. And while 12% of U.S. GDP comes from exports, our largest 2 trading partners are Canada (19% of exports) and Mexico (16% of exports) both of whom have worked out trade agreements with the U.S. This has given the U.S. increased leverage to negotiate with the remaining parties. China is third with close to 9% of U.S. exports. But Japan and Germany, which are 4th and 6th respectively, combined make up less than China. This is not to say that they don’t matter, but at only 7.9% of U.S. exports, combined they make up less than 1% of U.S. GDP. Thus the slowdown in their countries isn’t likely to have any measurable impact on U.S. GDP. (If these economies decline by 1% for a year and imports from the US decline by an equal amount, the impact to U.S. GDP would be 1% of 1% or 0.01%, and even if the impact was greater it’s not likely to be material).
Domestic demand drives U.S. economic growth, and household consumption makes up 70% of U.S. GDP. Moreover, the U.S. economy is very strong, perhaps too strong, and could debatably benefit from a softening in demand to help prevent the economy from overheating and so help preserve the length of this expansionary cycle.
Job openings across the economy remain at record levels. Openings relative to hires continue to hit new records almost monthly. We simply don’t have the workers to satisfy demand. (An article in the WSJ indicated that many firms are now hiring based only on a phone call, as if to confirm there’s a breathing person on the other end.) This is even true in the historically weak manufacturing sectors.
Data from Japan and Germany caused a knee-jerk overreaction last week. The U.S. can withstand a hit. Exports just don’t matter (much). The sun will rise in the east. And economic growth remains a bit too strong.