How Trump's tax cuts and the trade war have set the stage for a self-inflicted recession

New York(CNN Business) Cracks are beginning to form in the American economy, threatening to tip the country into recession. And at least some of those cracks are self-inflicted.

The biggest problem facing the United States economy is a slowdown that has struck China, Germany, South Korea and other manufacturing powerhouses.

President Donald Trump's escalating trade war with China has only amplified the pre-existing global growth slowdown. That overseas trouble has started to infect American factories, which are contracting for the first time in a decade.

"This could be the straw that breaks the camel's back," Gus Faucher, chief economist at PNC, said of the ongoing trade war. "I am more concerned about the US economy now than I have been throughout this expansion."

The United States is also coming off the 2018 sugar high of Trump's tax cuts and the bipartisan surge in government spending. There was always a risk that stimulating an already-healthy economy would backfire by creating a boom-to-bust scenario.

"You aren't supposed to do stimulus until you're in a recession — when you need it," said Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management. "We pulled demand forward before there was a recession, meaning we may in fact have caused the recession."

Recession signal flashes

Shalett said the United States will likely enter a recession in 2020 and warned the global economy may already be there.

"It is highly, highly likely that the US economy will continue to slow down," she said.

Red lights are flashing in the bond market, where the yield curve has inverted. Such inversions, where the 10-year Treasury yield dips below the two-year Treasury rate, have been reliable recession indicators in the past.

"The bond market already gets the joke. The stock market still doesn't," Shalett said, predicting a 10% tumble for stocks over time.

Although Trump said on Thursday that the US economy "is doing really well," the reality is more mixed and the outlook has darkened considerably.

The bright spot is consumer spending, the main driver of growth. Boosted by low unemployment, households continue to shop.

However, corporate spending has been soft. That's despite the fact that the tax overhaul was supposed to spark a wave of business investment on job-creating items like factories, software and equipment.

"Unfortunately, we saw a minimal short-term bump," said Lindsey Piegza, chief economist at Stifel.

Piegza estimates there is at least a 50% chance of a 2020 recession in the United States.

Trade war dings factories

Manufacturing has emerged as the problem child of the economy. Factory activity declined in August for the first time since September 2009, according to a report by IHS Markit.

"The trade war is exacerbating it," said Jeffrey Sherman, co-portfolio manager of the DoubleLine Core Fixed Income Fund. "A lot of it is self-inflicted."

DoubleLine Capital CEO Jeffrey Gundlach sees a 75% chance of a recession before the 2020 presidential election.

Trump escalated the trade war earlier this month by announcing plans to impose a 10% tariff on $300 billion of Chinese consumer goods, including TVs, smartphones and footwear.

"At the heart of the weakness is deteriorating trade relations," said Stifel's Piegza.

Manufacturing makes up a small portion of the overall US economy. But the risk is that the factory turmoil spills over into the rest of the economy. Wage cuts and layoffs would hurt consumer spending.

Unemployment claims have climbed by an average of 5% in key manufacturing states such as Michigan, Pennsylvania, Ohio and Wisconsin since US tariffs on China were imposed in September 2018, according to Bank of America. Iowa's jobless claims have jumped 16% over that span.

"Right now, we're not looking at recession conditions," Liz Ann Sonders, chief investment strategist at Charles Schwab, told CNN Business' "Markets Now." "But if that manufacturing malaise moves into consumer malaise, then the chances we're going to go in one or may already be in one go higher."

What if the trade war goes away?

Many still have confidence the United States will avert a downturn.

"The underlying economy is still doing okay. The chance of a recession in the near term is still relatively low," Goldman Sachs CEO David Solomon told CNN Business' Christine Romans.

A strong rebound in manufacturing would certainly lower the odds of a downturn. And that could come from powerful stimulus by China or a thaw in the trade war.

"We can reverse this," DoubleLine's Sherman said, "if the president turned around and got rid of the tariffs overnight."

Although Trump's trade war is causing trouble for the global economy, many have defended the desire to get China to play fair on trade. China's alleged intellectual property theft and forced technology transfers have real costs.

"I'm not a fan of tariffs, but we need to find a way to push," Solomon said.

$1 trillion budget deficit looms

Likewise, many viewed the decision to lower the corporate tax rates as a way to make American business more competitive globally.

However, the $1.5 trillion tax law wasn't paid for, causing government revenue to decline. And Trump has enacted bipartisan agreements to ramp up government spending.

That one-two combination amounted to a strong dose of fiscal stimulus normally reserved for a recession or severe slowdown.

The Congressional Budget Office now projects the deficit will reach $1 trillion in the 2020 fiscal year, two years earlier than previously estimated. Surging deficits could leave Washington with less ammo to fight an actual recession.

"It's not the legislation I take issue with. It's the timing of the legislation," Piegza said of the tax law. "We were already on a tremendously dangerous trajectory."

Trump has sought to shift the blame for a potential recession to the Federal Reserve. The president has repeatedly slammed Jerome Powell, his handpicked Fed chief, for raising interest rates. Trump now wants the Fed to slash rates.

Although Powell may want to take a mulligan on the Fed's final rate hike, the central bank was trying to prevent Trump's tax cuts from causing the economy to overheat. And despite those rate hikes, borrowing costs are not elevated.

"Lowering rates isn't really going to solve what ails this economy," said Morgan Stanley's Shalett.

'Garden-variety recession'

The good news is that even those who see a potential recession on the horizon don't fear a repeat of the last downturn, which was the worst in a generation.

"It's still going to cause pain but not nearly as bad as the Great Recession," said Faucher.

He noted that US GDP plunged by 4% from peak-to-trough during that crisis, or roughly twice as much as a "normal" recession.

Of course, few saw just how disastrous the Great Recession would be until it was already too late.

One major difference is that economists don't see an epic bubble ready to burst like the real estate and tech bubbles that popped during last decade's recessions.

"It's going to be a garden-variety recession. It's not a crisis or Armageddon," said Shalett.

Although recessions can be painful, they are also a natural part of the business cycle. Downturns wash away prior excesses, setting the stage for longer-term growth.

"Recessions aren't bad. We've lived through many recessions. There is cleansing that happens," Shalett said.

And this cleansing may at least partially be self-inflicted.