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Joshua Roberts | Reuters

The threat of the U.S.-China trade war escalating into something beyond nasty rhetoric and modestly effective  tariffs for the most part has been dismissed by market participants and economists.

But the idea that the dispute could turn into something more is starting to become reality.

Tuesday’s relief rally on Wall Street notwithstanding, several under-the-radar indicators are pointing to the danger that a prolonged conflict could put a serious dent into the economy of both nations, and reverberate through a global picture that at best looks tenuous.

Whether it’s increased expectations for interest rate cuts, decreasing expectations for inflation or queasy bond and stock market investors who are more aggressively pricing in slower growth, the message is being sent to the U.S. and China that danger lurks.

“The bottom line here is pretty simple if not altogether positive: markets are signaling that both the US and China have blundered into a minefield,” Nicholas Colas, co-founder of DataTrek Research, said in a note Tuesday. “The risk of a US recession is rising, sharply and quickly.”

Colas points to the various indicators on inflation, rates and concerns over the Chinese dumping U.S. Treasurys as indicators from the markets that the two sides should heed, much the same way as the Fed took cues that it was making a policy mistake by continuing to raise interest rates.

“When markets signaled to [Fed] Chair [Jerome] Powell that he was on the brink of a policy mistake, he changed course. American and Chinese negotiators could learn from that,” Colas wrote.

There is an assortment of concern pointing toward tougher times ahead:

  • The New York Fed’s gauge of recession probability over the next 12 months is now at 27.5%, easily the highest since the financial crisis.
  • The Citi Economic Surprise Index, which measures actual data readings vs. expectations, just recently bounced off its lowest reading in nearly two years and remains well in negative territory.
  • Inflation expectations are dimming as well, with the spread between the 5-year Treasury note and the 5-year Treasury Inflation Protected Security — known as the “breakeven” — pointing to 1.75% inflation, below the Fed’s desired 2% level.
  • Investors continue to reprice Fed rate actions, with a nearly 50% chance now assigned to a September cut and a 29% probability of two quarter-point reductions before the end of 2019, according to the CME. The change intimates a loss of confidence in growth and expectations that the central bank will have to step in and ease policy. Though Minneapolis Fed President Neel Kashkari told CNBC on Monday that he doesn’t see a change in policy ahead, the market feels differently.

The developments come against an otherwise positive economic backdrop.

Unemployment is at a 50-year low, GDP rose 3.2% in the first quarter and small business confidence rose again in April, according to the National Federation of Independent Business survey released Tuesday that showed its index rising 1.7 points to 103.5.

Kashkari also said he sees the U.S. in a more advantageous position than China in the trade battle.

‘It’s like lighting a match’

Still, the NFIB survey came before the latest round of trade headlines. Market reaction showed that the ecosystem around the economy and the trade headlines remains fragile.

“The economic backdrop is still positive, the market is still up year to date. But the concern now is that this takes on a life of its own,” said Quincy Krosby, chief market strategist at Prudential Financial. “It’s like lighting a match. You think you know how to control it. That’s where the uncertainty comes in.”

During a scrum with reporters Tuesday, President Donald Trump called the situation with China “a little squabble” and said his relationship with President Xi Jinping remains “extraordinary.” Stocks rallied strongly after Monday’s aggressive sell-off.

But the rhetoric in the trade war has seesawed between confrontational and adversarial, and markets are beginning to focus on the possibility of a negative outcome.

“What happens is once you start to escalate the verbiage and make it personal, and this is true in actual wars and is true in trade wars, then the uncertainty intensifies,” Krosby said.

Investors are “moving into a more defensive posture” as the negotiations drag on, with allocations likely to stay that way until there is greater clarity, she added.

“Just like in war, you’re looking for escalation or whether or not it can be defused, and then you sit down at the negotiating table,” Krosby said. “Investors are waiting for something more concrete and viable, and it may take time.”

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OECD cuts growth outlook to post-crisis low

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The trade war between the United States and China has plunged global growth to its lowest levels in a decade, the OECD said on Thursday as it slashed its forecasts.

The Organisation for Economic Cooperation and Development said that the global economy risked entering a new, lasting low-growth phase if governments continued to dither over how to respond.

The global economy will see its weakest growth since the 2008-2009 financial crisis this year, slowing from 3.6% last year to 2.9% this year before a predicted 3.0% in 2020, the OECD said.

The Paris-based policy forum said the outlook had taken a turn for the worse since it last updated its forecasts in May, when it estimated the global economy would grow 3.2% this year and 3.4% in 2020.

“What looked like temporary trade tensions are turning into a long-lasting new state of trade relationships,” OECD chief economist Laurence Boone told Reuters.

“The global order that regulated trade is gone and we are in a new era of less certain, more bilateral and sometimes assertive trade relations,” she added.

Trade growth, which had been the motor of the global recovery after the financial crisis had fallen from 5% in 2017 into negative territory now, Boone said.

Meanwhile, trade tensions have weighed on business confidence, knocking investment growth down from 4% two years ago to only 1%.

Boone said that there was evidence that the trade standoff was taking its toll on the U.S. economy, hitting some manufactured products and triggering farm bankruptcies.

The world’s biggest economy would grow 2.4% this year and 2.0% next year instead of the 2.8% and 2.3% respectively that the OECD had forecast in May.

Global Economy Screen with world map and man

Stephen Morton | Bloomberg | Getty Images

Brexit Britain

China would also feel the pain with the second-biggest economy growing 6.1% in 2019 and 5.7% in 2020, outlooks the OECD cut from 6.2% and 6.0% previously.

The OECD estimated that a sustained decline in Chinese domestic demand of about 2 percentage points annually could trigger a significant knock-on effect on the global economy.

If accompanied with a deterioration in financial conditions and more uncertainty, such a scenario would mean global growth would be cut by 0.7 percentage points per year in the first two years of the shock.

Meanwhile, uncertainty over government policies was also hitting the outlook for Britain as it lurches towards leaving the European Union.

The OECD forecast British growth of 1% in 2019 and 0.9% in 2020, but only if it left the EU smoothly with a transition period, a far from certain conclusion at this stage. The OECD had forecast in May growth of 1.2% and 1.0%.

If Britain leaves without a deal, its economy will be 2% lower than otherwise in 2020-2021 even if its exit is relatively smooth with fully operational infrastructure in place, the OECD said.

The euro area would not be spared from negative spillovers under such a scenario and would see its gross domestic product cut by half a percentage point over 2020-2021.

The OECD trimmed its forecast for the shared currency block, largely due to the slowdown in its biggest economy, Germany, which was estimated to be in a technical recession.

Euro zone growth was seen at 1.0% – down from 1.2% in May – this year and 1.0% in 2020 – down from 1.4% in May.

Boone said Germany’s economy had probably shrunk in the second and third quarters with a slump in car manufacturing, which accounts for 4.7% of German GDP, knocking three-fourths of a percentage point off German growth.

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Netanyahu urges rival Gantz to form unity government

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Israeli Prime Minister Benjamin Netanyahu delivers a speech to supporters of his Likud party after polls closed in the Israeli parliamentary elections.

Ilia Yefimovich | picture alliance | Getty Images

Prime Minister Benjamin Netanyahu called on Thursday on his main rival, former general Benny Gantz, to join him in a broad, governing coalition after Israel’s election ended with no clear winner.

A spokeswoman for Gantz, leader of the centrist Blue and White party, had no immediate response to the surprise offer from Netanyahu, head of the right-wing Likud party.

The change of strategy reflected Netanyahu’s weakened position after he failed again in Tuesday’s election, which followed an inconclusive ballot in April, to secure a parliamentary majority.

“During the election campaign, I called for the establishment of a right-wing government but to my regret, the election results show that this is impossible,” Netanyahu said.

“Benny, we must set up a broad unity government, as soon as today. The nation expects us, both of us, to demonstrate responsibility and that we pursue cooperation.”

On Wednesday, Gantz said he hoped for a “good, desirable unity government”. But he has also ruled out forming one with a Netanyahu-led Likud, citing looming corruption charges against the prime minister. Netanyahu denies any wrongdoing.

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How Saudi Arabia failed to protect itself from drones, missile attacks

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Smoke is seen following a fire at Aramco facility in the eastern city of Abqaiq, Saudi Arabia, September 14, 2019.

Stringer | Stringer

DUBAI — Questions have abounded all week as to how Saudi Arabia, the planet’s third-highest defense spender and steward of the world’s largest oil facility, allowed itself to fall victim to a drone and missile attack that wiped out half of its crude production in a day.

“The Saudi leadership has a great deal of explaining to do that a country that ranks third in terms of total defense spending … was not able to defend its most critical oil facility from these kinds of attacks,” former U.S. diplomat Gary Grappo told CNBC on Tuesday.

The stakes for the future of Saudi Arabia’s ability to defend itself are global. Brent crude saw its largest price jump ever as markets opened this week, and the commodity’s next moves depend heavily on Saudi oil giant Aramco’s ability to recover its production capacity and defend itself from similar attacks.

Investors are likely asking themselves how the kingdom could have left itself so vulnerable and what that means for the future of oil, global markets and the long-awaited Aramco public stock offering.

So how did the Saudis, who in 2018 spent an estimated $67.6 billion on arms — second only to the U.S. and China — fail to defend their economic jugular vein?

A target like ‘a Christmas tree’

The Saudis have a lot of sophisticated air defense equipment. Given their general conduct of operations in Yemen, it is highly unlikely that their soldiers know how to use it.

Jack Watling

Land warfare expert, Royal United Services Institute

It also doesn’t help that massive oil plants are just easy targets.

“Saudi oil assets are vulnerable for the simple reason that when flying over them at night, they stick out against the desert background like a Christmas tree,” Michael Rubin, a former Pentagon official and Middle East expert at the American Enterprise Institute, told CNBC in an email.

“This means that enemies don’t need high-tech GPS-guided drones, even though they might have them, but can also use relatively lower technology drones.”

Drone wreckage including one described as an Iranian Delta Wave UAV, foreground, from the attack on the Aramco Abqaiq oil refinery, sits on display during a Ministry of Defense news conference in Riyadh, Saudi Arabia, on Wednesday, Sept. 18, 2019. Saudi Arabia on Wednesday said the weekend attacks on the kingdoms critical oil infrastructure were “unquestionably sponsored by Iran.” Photographer: Vivian Nereim/Bloomberg via Getty Images

Vivian Nereim | Bloomberg | Getty Images

Twenty-five drones and missiles were used in the Saturday strikes on state oil giant Saudi Aramco facilities Abqaiq and Kurais, Saudi’s defense ministry said. While claimed by Yemen’s Houthi rebels, Saudi and U.S. officials say Iran was responsible, a charge Tehran has denied.

Dave DesRoches, an associate professor and senior military fellow at the National Defense University in Washington, D.C., told CNBC: “If an attack is of a different threat than the system was designed for — that is a low-altitude cruise missile instead of a high-altitude ballistic missile — then the system will not intercept it.”

Saudi Arabia’s current air defenses are ‘irrelevant’

Saudi Arabia boasts an arsenal of sophisticated and expensive air defense equipment. They have the American-made Patriot missile defense system, German-made Skyguard air defense cannons and France’s Shahine mobile anti-aircraft system, and they’ll soon have Lockheed Martin’s highly advanced THAAD (terminal high altitude area defense) interceptors.

But these are basically inconsequential, says Jack Watling, a land warfare expert at the Royal United Services Institute who advises Gulf militaries.

“The Patriots are kind of irrelevant,” Watling told CNBC in a phone interview. “The track record of Patriot engaging missiles of any kind is pretty awful, they very rarely hit the target.” The other issue, he says, is that it’s designed for shooting down high-altitude ballistic missiles, not the cruise missiles and drones used in Saturday’s attack.

“These were low-flying cruise missiles. They were coming in far below the engagement zone for Patriot. So you wouldn’t have tried to hit them with Patriot.” In its primary role of shooting down aircraft, Watling noted, the system does perform “very well.”

Aerial photographs found on open-source platforms show three Skyguard batteries placed around the targeted Abqaiq oil facility, which are slow-firing large caliber anti-aircraft guns, as well as French-made Shahine batteries from the 1980s.

Despite being permanently placed to protect these facilities, they Skyguards were not of much use either, Watling says: “The batteries around the site are firstly not the appropriate systems to engage cruise missiles, and there is no evidence that the Saudis have trained using their equipment.”

‘The Saudis… are largely inattentive’

To add to the Saudis’ weapon woes, their military personnel may not be up to the task either, according to Watling and several other experts who spoke to CNBC anonymously.

“The Saudis have a lot of sophisticated air defense equipment. Given their general conduct of operations in Yemen, it is highly unlikely that their soldiers know how to use it,” Watling said. He added that the kingdom’s forces have “low readiness, low competence, and are largely inattentive.”

“So if you’re a battery commander protecting against an oilfield which you never believed was going to come under attack, how carefully are you watching your radar? I’d be surprised if they’d even turned their radar on.”

Even those that do have the technical knowledge, Watling added, “are unlikely to be attentive enough to pick up small unmanned aerial vehicles or low flying missiles on their radar… quickly enough to coordinate countermeasures.”

The Saudi Defense Ministry did not respond to a CNBC request for comment.

In the Saudi military’s defense, oil infrastructure in the kingdom falls under the Ministry of Interior (MOI), military, noted Becca Wasser, a security analyst and war gaming expert at RAND Corp in Washington, D.C.

“Most of U.S. arms sales to KSA, particularly in air defense, have been to the military,” she wrote on Twitter on Monday. “The MOI, to my knowledge, isn’t well kitted out for this role as they tend to focus on domestic threats.”

So what does the kingdom need to do?

Barely a month has gone by since 2016 without Yemen’s Houthis firing rockets or missiles into the kingdom, which has been mired in a bloody war with the rebels since 2015. The Saudi-led offensive in Yemen has led to tens of thousands of deaths, according to the United Nations.

But to achieve the kind of point defense that could counter future attacks like Saturday’s, the Saudis need better short-range air defense systems and lower level search-and-track radar, experts say. “More importantly,” RUSI’s Watling added, “they would need soldiers who were competent at using them, and attentive.”

“If the Trump Administration is serious about confronting Iran in the region, it’s doing an abysmal job preparing for the small and big fights where the IRGC and its proxies can bring asymmetric weapons to bear,” Miguel Miranda, founder of website the 21st Century Arms Race, wrote last year in an op-ed for RealClearDefense.com.

“Genuine layered anti-ballistic missile defenses are needed to protect U.S. bases against hundreds of potential missile and rocket attacks by Iran in a future war.”

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