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Jeff Meli Michael Gapen

Episode 18

Jeff Meli in conversation with Michael Gapen

Planes, politics & viruses: Emerging risks to US growth?

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When a host of potentially significant global macroeconomic risks resolved at the end of 2019, financial markets responded favourably. However, a new set of macroeconomic stresses has simultaneously emerged at the start of 2020 and collectively may pose a threat to US and global growth.

In episode 18 of The Flip Side podcast, Jeff Meli, Head of Research, and Michael Gapen, Head of US Economics Research, debate the degree to which these new risks – the issues at Boeing with the 737 Max, the rise of the Novel Coronavirus, and the inherent uncertainty of the US presidential nomination process – may affect the US growth outlook and business confidence.

  • Jeff Meli:
    Welcome to the latest episode of the Flip Side. I'm Jeff Meli, the global head of research at Barclays. Now, at the end of 2019, there were a number of potentially serious economic risks that got resolved positively.

    These include the fact that we signed the new USMCA. That's the new trade agreement that the U.S. has with Mexico and Canada. And the U.S. reached phase one agreement with China, which has dramatically reduced the trade tensions on that front.

    There were also some political developments, like the U.K. election reduced the possibility of a hard Brexit. And we're able to get the federal government in the U.S. funded for the next two years, which has sort of taken the government shutdown risk off of the table.

    Now, all this was taken really positively by financial markets. We've had a very substantial equity market rally. And more importantly for the economy, it seems to have removed some hurdles that were out there for U.S. growth. We've seen business confidence tick up. We've seen the labor market remain strong. And it seemed like the skies were brightening.

    But that window didn't seem to remain open for too long, because more recently, a couple of new risks have emerged. Now, these might be manageable on their own, but they're coincidentally timed, and together they might actually pose a risk to this expansion, which is now the longest expansion on record. So, I want to talk specifically about three issues.

    First, the continued problems at Boeing with their 737 MAX plane. Second is the rise of the novel coronavirus, which was obviously emerging from China and then spreading globally. And then potentially, the concerns that investors might have that a very progressive candidate emerges from the Democratic primary process.

    So, joining me today to discuss these issues is Michael Gapen. He's our chief U.S. economist. And we're going to debate the degree to which each of these risks could affect U.S. growth. Thanks for joining me, Mike.

    Michael Gapen:
    Thanks for having me, Jeff.

    Jeff Meli:
    All right. So, the consensus view is that the U.S. is going to grow at trend, the labor market's going to remain healthy, inflation will firm a bit but stay, you know, at or below the fed's target. And that means the fed stays on the sideline for the year, and it's a very benign and even positive outlook for the U.S. economy.

    Now, that may be correct, but I think that outlook underestimates the combined effect of the three risks that I laid out. So, we usually look at these risks in isolation, and we try to see if any one individual risk could be the source of a recession. But, you know, maybe it's too easy to look at it that way, because individually, you could dismiss those. But the timing isn't good. They're all happening at the same time. And together, they could play off of each other and maybe cause more severe damage. That's --

    Michael Gapen:
    So, I hear that. I just -- I think you're overstating the case. So, we continuously review our base case in our outlook for the U.S. economy. And without minimizing any of the three risk factors that you mentioned, and in particular the coronavirus, which is obviously causing a hardship to people in China right now, we just don't see implications for U.S. growth, certainly not beyond the first and second quarters.

    And even if there is, we would expect some bounce back to recapture at least some or maybe all of that lost activity in the second half of the year. And on politics, I just think it's too early and we're overstating the importance of Iowa.

    Jeff Meli:
    All right. Let's get into it. So, we can start with Boeing. So, to recap on that side, there's been some serious problems with Boeing's new long-haul jet, the 737 MAX that came to light last year after two pretty severe accidents, one in Asia and one in Africa.

    It took some time to realize just how big this problem was, but in the end, Boeing needed to suspend production of the plane, which they did in mid-December. So, there's a lot of, like, safety and governance issues that have come to light because of this issue.

    But from a purely economic standpoint, I think the most surprising and sort of underappreciated aspect of this is just how important Boeing commercial jet production is to the U.S. economy.

    Michael Gapen:
    Yeah, that's right. I mean, even reviewing this, the numbers were a bit of a surprise to us. Certainly, Boeing is maybe the largest manufacturer in the U.S., but when we -- when we turn to national income and product accounting, we estimate that the value added of each 737 MAX to GDP is about a 120 million. Now, maybe we estimate about a third of that as import content. So, that leaves domestic value added at about 80 million per plane.

    So, if you're talking about going from 42 planes a month to zero, that adds up. And that's a sizable hit. So, to put numbers on it, the direct effect of the Boeing suspension on 737 production is that it will likely reduce U.S. GDP growth by a half a percent in the first quarter. And we've taken our forecasts down from 2 percent to now 1.5 percent as a result of the suspension.

    So, I admit this is a big number. It's a bit of a surprise coming from just one company, but when you put it in perspective against the size of a $22 trillion economy, we think the economy is capable of handling this magnitude of a temporary disruption.

    Jeff Meli:
    Okay. Well, I think the keyword that you said there was temporary, because obviously, there's a lot of uncertainty about when the plane's going to come back into production. And there's been some recent news of, for example, new software problems that have been discovered. And there's maybe a chance that this problem lingers for longer than people are expecting.

    Michael Gapen:
    Right. I mean, we don't know when or if the 737 MAX will be recertified by regulators. All that we've heard from the FAA is the process will extend into 2020. And indications are that production will be halted through June. So, that's what we've assumed, that production will be halted through June, and then you'll get a rebound in production after that.

    So, an earlier recertification would certainly mean more minimal GDP effects, while an extended recertification process would likely lead to a larger drag on activity than we anticipate. So, we've assumed things rebound or production resumes in Q3, but that could be too optimistic.

    Jeff Meli:
    All right. Now, a second issue with the analysis is that you focused on the direct effect. So, that means the GDP associated with Boeing production itself.

    Michael Gapen:
    Right. Right.

    Jeff Meli:
    That doesn't really include the knock-on effects, like, for example, to suppliers, which is a lot more difficult to measure.

    Michael Gapen:
    Right. So, we are assuming in our numbers that the temporary suspension of 737 production will have little to no effect on Boeing suppliers. So, just as a little background here, the production of an aircraft at Boeing is an extremely complex just-in-time process. It precisely sequences inputs in specific order to construct a 737 in only nine days. So, our assumption here is Boeing has vested interest in keeping its suppliers as whole as possible during this process given their established expertise in the production process itself, which is very complicated.

    But I think it's fair to say a long suspension is likely to have at least some downstream effects on suppliers. So, during this expansion, though, I would just argue the economy has -- the U.S. economy has shown a particular resilience to push through a lot of headwinds. It may be a mediocre expansion in terms of average growth rates, but slow hasn't meant fragile. I think slow has meant durable.

    Jeff Meli:
    You know, a major difference, Mike, with this particular concern around Boeing compared to some of the other hurdles that the economy has surmounted, say, for example, the trade tensions we went through in 2019, is that the weakness from Boeing is concentrated in one specific segment of the economy. It's not dispersed. So, for example, half a percent less growth but spread out over many sectors might mean less to the economy, might sort of pose fewer recession risks.

    It could be that, like, the consequences are employees get slightly lower raises or a company's margins contract slightly. Whereas when you concentrate that pain in one specific sector, it's more likely to have a consequence of lost jobs or companies going out of business.

    And I think some of the concern I have about this issue is we're applying sort of that generic half a percent and thinking about what that means as it flows through as opposed to thinking more concentrated what the effect could be.

    Michael Gapen:
    Well, Jeff, then I think the key issue is when will this be resolved? So, you don't get the kind of contagion -- or I'd suggest you won't get the kind of contagion you're talking about over one or two quarters given at least what I think is underlying strength in the economy. And, in fact, I'd argue you'll get a bounce once this is resolved. So, if they were producing 42 planes a month before the suspension, we argue that some of that lost activity will be made up when production restarts.

    So, our credit and equity research teams see production as rising to 50 or 55 planes per month following recertification. So, maybe we never get all that activity back, but what we see right now is a temporary suspension followed by a long bounce. And I don't think that's something to get too worked up about. And I don't really feel like it's a recession trigger.

    Jeff Meli:
    Right. Now, you used the word contagion, which I think actually is a good segue into the second risk that's arisen recently, which is the novel coronavirus. The virus has continued to spread rapidly. According to WHO estimates, the number of confirmed cases continues to rise. Our data science team has produced some models of the spread of the virus, and that suggests that it's still growing at an exponential rate, which means that, at least so far, the quarantine efforts have failed to sort of stem the tide.

    Now, financial markets have in the sort of moment been reacting to this news. You've seen stock markets rally and sell off as news of the virus has sort of come to light. But at this point, I think it'll be very fair to say that as we're setting new highs that the -- in aggregate, the stock market and other financial assets really don't reflect any sort of novel coronavirus risk. It's not priced right now in the markets.

    So, if markets are making a mistake, it could be maybe that it's the low mortality rate that's lending confidence to investors. It does appear to have a lower mortality rate than, say, SARS or even MERS, for example, which is the highest mortality rate of any of those sorts of viruses. And many analysts think that governments are better positioned to sort of eventually contain something with a lower mortality rate but high contagion. But it's possible that those actually have larger negative economic effects than viruses that are less contagious but have higher mortality rates.

    Michael Gapen:
    So, yes, that's correct. And it may go against your thinking, but the academic evidence does suggest that high-infection-rate viruses are likely to have much more pronounced negative effects on activity since the efforts to avoid spreading of the disease, like quarantines and shuttered factories, are all a drag on economic activity.

    But our China economics group did some detailed scenario analysis of the effect of the novel coronavirus on Chinese growth, and they've come up with mild and moderate and severe scenarios, because obviously we don't -- we don't know a lot and there's still a lot of uncertainty out there. And it's only in the mild and moderate cases -- you know, we don't really see a material route across to the U.S.

    You really have to hit that most severe scenario, where the reduction in Chinese growth starts to be felt here. It's just -- you know, it is a fact that the U.S. is just not an export-driven economy.

    Jeff Meli:
    All right, Mike. I think, like in the Boeing case, there's an issue here of concentration. So, I think there's a difference between sort of a generic slowdown in Chinese growth versus very specific parts of the Chinese and I think global economy that suffer as we try to avoid further spread of the virus. So, I'll give an example: tourism. It's estimated that China accounts for 20 percent of global tourism.

    Chinese tourists spend more money than tourists from any other country, more than twice as much as the U.S., which is actually the second highest tourist spending, you know -- you know, country. That's a direct hit to the countries that Chinese tourists travel to. It's just straight-up lost activity. It's not going to be made up in further quarters like the case in Boeing planes. And it's concentrated in a very specific industry.

    Now, some of these tourism issues are going to be localized within China. So, for example, Macau has closed their casinos for two weeks. And it's also -- could affect other parts of Asia. Like, our economists think, for example, Thailand could be particularly exposed, because there's normally an enormous amount of Chinese tourism to Thailand. But we're not going to be immune to this here in the U.S. either.

    Michael Gapen:
    So, I think you can make that case. As incomes in China have grown so has tourism. You make some good points about tourism from China to the rest of the region. It shows up here in the U.S. So, for example, in 2019 -- it was also, I believe, the same in 2018 -- about three million Chinese visited the U.S. and spent an average of about $7,000 per visit.

    That's about let's call it 20 billion in exports for the U.S. If that number went to zero -- so, if tourism ground to a halt all in one quarter, that would shave about four-tenths of a percent off of US growth.

    Jeff Meli:
    Yeah. That's on top of the half a point that we just lost because of the Boeing planes. And I think that's my point, that these things are happening at the same time.

    Michael Gapen:
    Right, right. But that's -- again, that's a worst-case scenario. So, I'm not suggesting SARS is the perfect case study for this, but even in the SARS episode, Chinese tourists to Japan, that number fell by 40 percent. That's a pretty sizable number. The decline to the U.S. wasn't as large.

    So, having it go to zero, I think that's a -- that's certainly a worst-case outcome. The number's likely to be smaller. Certainly, it's something we have to watch. The actual effect is just likely to be smaller than the extreme one. And again, it should be temporary. Under all but the most severe outcomes, we don't think this lingers into the second half of the year.

    Jeff Meli:
    Okay, so supply chains. I want to move on to that. That's another area --

    Michael Gapen:
    Okay.

    Jeff Meli:
    -- where we could see concentrated effects. Now, we've already seen reports in the news of, for example, Korean auto manufacturers having to shut down assembly plants, because they're missing key parts that they were importing from China. Now, in a lot of cases, supply -- if there's a disrupted supply chain, you could find an alternative someplace else in the world.

    But in some cases, like, for example, tech and autos to areas with a substantial presence in Hubei, which is the sort of epicenter of the virus, there may not be very readily available alternatives out there. Rare earth metals. That's a key input into smartphones and electric vehicles. Also, very, very located in China. Very difficult to replace from elsewhere in the world.

    Michael Gapen:
    So, I just suggest we should be careful to extrapolate, or I -- in this case, not extrapolate linkages between China and Korea or China and Taiwan into the U.S. I think the U.S. is not as dependent on China as other countries in Southeast Asia are. And I think that was demonstrated in the trade tensions and the tariff story that we just saw.

    I do think companies have been forced to think of alternatives since the tariffs with China kicked off around two years ago. So, I think companies are in the mode of thinking about building in redundancies.

    So, yes, there may be a few special cases like electronic vehicles and lithium as you mentioned, but I believe those are the exception and not the rule. And I'd go back to my main point that so long as quarantines and the other measures that the government has taken, as painful as they are likely to be in the short run, I think they will effectively avoid the worst-case scenario. So, as long as that's the case, then it should be temporary and should end up only being a minor speed bump for the U.S.

    Jeff Meli:
    All right. So, one final point I want to make on the -- on the virus is its potential effect on business confidence. Now, business investment is a real question mark in our U.S. outlook.

    Michael Gapen:
    That's right.

    Jeff Meli:
    Investment was weak last year in 2019, and we needed to rebound in order to maintain the momentum of the expansion. And I think it's possible that the spread of the novel coronavirus and all the uncertainty that comes along with it is just another excuse for businesses to avoid investing. Maybe last year it was trade. This is the excuse for this year.

    And actually, following on from that, I can think of another reason for businesses to hold off in 2020, and that's the presidential election. And you know, in terms of the electoral cycle right now, the uncertainty about just who's going to emerge from the Democratic primary process.

    Michael Gapen:
    So, I do agree that we need to watch business confidence carefully. And I think you identified the exact right point, that there is a risk that the company that chose not to spend last year because of trade uncertainty decides not to spend this year either for reasons of the coronavirus or uncertainty about changes in policy outcome.

    So, I think it would be very difficult to maintain the momentum that we've had in U.S. labor markets if investment doesn't pick up. I don't think firms that are holding off on spending are going to keep hiring forever. I do think something there would have to give.

    Jeff Meli:
    Okay. So, let's think about this Democratic primary, which is the last risk that I want to assess. I do think that there are potential risks to business confidence in this process. So, I want to be clear here. We not commenting on any of the long-term implications of the policy proposals that have been proposed by various of the candidates. We haven't done the work on that. And honestly, I think it's way too early in the political process to really take any of those proposals seriously enough to start diving into the economic implications.

    That said, I think it's fair to say that the sort of big structural change that gets advocated by some of the more progressive candidates could bring a higher degree of uncertainty. And that could affect markets for sure in the short run, but it could also be a drag on business confidence. Now, you know, that, I think, would be a greater drag than, say, potentially a more centrist candidate.

    And again, that's not to say that any of their proposals won't, in the long run, be beneficial to the economy. I just think it's a rise in uncertainty, because big structural change sounds like something that, you know, if I were running a business might be cause for a delay in terms of some of my big spending programs.

    Michael Gapen:
    It's not clear to me that the composition of Democratic voters in Iowa is fully representative of the broader party. Certainly, it's not as demographically varied as some of the other primary states are. You have to get into South Carolina and Nevada for the electorate to be more diverse. And I'd also argue if you -- if you add up the vote totals from Klobuchar and Biden and Buttigieg, that number is above 50 percent.

    So, it may be still that that electorate, which is viewed as perhaps liberal, still more than half of it preferred a more centrist candidate. So, our view has been on Iowa despite -- we didn't obviously predict the uncertainty that was going to come out of Iowa and getting vote totals done, but we did write that we thought coming out of Iowa, there'd still be three or four viable candidates.

    So, we thought investors should look through Iowa. That's what we wrote recently in research reports. And in our view, we need to be focused on South Carolina and Super Tuesday. We think that's where it'll become more clear which candidate is likely to emerge.

    Jeff Meli:
    Well, Mike, we clearly have a long road ahead of us until November, and there'll be a lot more to be said about the primary process. Now, to read our latest thinking on these topics, clients can read "China Coronavirus: Evaluating the potential economic impact," and our -- from our economics team, "The cost of containment" and "Boeing 737 MAX suspension to weigh on Q1," all available on Barclays Live.
     

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About the analysts

Jeff Meli is Head of Research within the Investment Bank at Barclays. Jeff joined Barclays in 2005 as Head of US Credit Strategy Research. He later became Head of Credit Research. He was most recently Co-Head of FICC Research and Co-Head of Research before being named Head of Research globally. Previously, he worked at Deutsche Bank and JP Morgan, with a focus on structured credit. Jeff has a PhD in Finance from the University of Chicago and an AB in Mathematics from Princeton.

Michael Gapen is Head of US Economics Research at Barclays. Based in New York, he is responsible for the firm's outlook for the US economy, in particular, US monetary policy and the effect of financial markets on the economy. Prior to taking on this role, Michael was a Senior US Economist and, following his appointment as Asset Allocation Strategist in January 2012, he took on additional responsibility for forming the firm's asset allocation views. Michael holds a PhD in Economics from Indiana University.

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