Are we heading for recession and what it means for the Investment Market?
The past week saw share markets remain under pressure as the trade war rolled and Chinese and German economic data was weak leading to an intensification of global growth fears particularly after declining US bond yields saw a further inversion in the US yield curve. While Chinese shares rose on stimulus hopes US, European and Japanese shares fell, leaving global shares down around 6% from their July high. Reflecting global growth fears along with some weak profit results Australian shares had another bad week with the biggest falls being seen in communication services stocks on the back of Telstra’s earnings result, energy and material stocks and financials, and only the defensive health sector seeing a gain on the back of good earnings news. Australian shares are also down about 6% from their July high. Global growth worries and expectations for further monetary easing saw bond yields fall sharply with the Australian 10-year bond yield hitting a new record low of 0.85%. While metal prices rose slightly, the oil price was flat, and the iron ore price fell further. The $A was little changed as the $US rose.
Global growth risks are increasing. This was evident over the last week with much slower than expected Chinese activity data for July and the manufacturing heavy German economy contracting in the June quarter. Uncertainty flowing from President Trump’s trade wars are the big factor here as businesses are delaying investment decisions on the grounds that they could be rendered uneconomic by another tweet from Trump and slower growth in China which is partly trade war related is impacting countries like Germany, Singapore and the rest of Asia. The turmoil in Hong Kong, Brexit in the case of the UK, tensions with Iran, political uncertainty in Italy and an increasing risk that the Peronists will get control of Argentina again are adding to the risks. This is all driving share markets, commodity prices and risk currencies like the $A down and safe haven demand and expectations for further monetary easing are driving bond yields down. While Trump’s latest flip flop to delay some of the 10% tariff hikes due in September to December provided brief relief it didn’t last long as the uncertainty for business remains intense.
Inverting yield curves are not always reliable indicators of recessions – but should not be ignored. An outworking of falling bond yields is that long-term bond yields are falling below short-term yields. This happened briefly in the US in the last week in relation to the gap between the 10 year and 2 year bond yields but had already happened a few months ago in relation to the gap between the 10 year yield and the Fed Funds rate. See the next chart. This so called “inversion” is causing increasing consternation as an inverted US yield curve has preceded US recessions so it’s natural for investors to be concerned. But the yield curve may not be a reliable recession indicator: it can give false signals (circled on the chart); the lags from an inverted curve to a US recession averaged around 18 months in relation to the last three recessions so recession may still be some time off; various factors unrelated to US recession risk may be inverting the curve such as increasing prospects for more quantitative easing pushing down bond yields globally, negative German bond yields dragging down US yields and investor demand for bonds as a safe haven from shares; yield curves may be more inclined to be flat or negative when rates are low; and we have not seen the other US signs of imminent recession such as over investment, rapid debt growth, excessive inflation and tight monetary policy. So our base case remains that the US is not about to go into recession and this should support shares on a 6-12 month horizon. That said the message from bond markets should not be ignored and it does indicate rising risks to the global economy.
Source: NBER, Bloomberg, AMP Capital
While further global monetary easing should help alleviate the risk of US/global recession, failure to resolve Trump’s trade wars will work in the opposite direction. I remain of the view that at some point Trump will crack and negotiate more seriously and reasonably with China – because he knows that US presidents in the post war period have not been re-elected if there is a recession and unemployment is rising prior to the election (as was the case for Ford in 1976, Carter in 1980 and Bush snr in 1992). Such events are invariably associated with bear markets in shares. Trump is showing signs of getting twitchy – as evident in the postponement of the 10% tariff on some goods and his comment that he plans to talk with President Xi soon on trade – but it’s not enough. Further share market falls are likely until Trump relents and there is a durable fundamental solution and the Fed and other major central banks undertake (or at least signal) a lot more easing. A share market correction was due after the strong gains into July and the August-October period is seasonally weak for shares. Well at least President Trump is reportedly looking into the US buying Greenland – maybe that will help?
Australia is not in the trade war but anything that weakens global growth threatens our exports and confidence, so we are naturally seeing a fall in the Australian share market and bond yields just like we did last year when the trade war started. Similarly, the Australian yield curve has also gone negative with 10 year bond yields of 0.87% below the cash rate of 1%. But its worth noting that Australian yield curve inversions in 2000, 2006-2008 and in 2012 were totally useless as recession indicators.
August 16th marks the 42nd anniversary of the apparent death of Elvis at the age of 42. Suspicious Minds from 1969 would have to be his best song, but Moody Blue would have to be his second best. It was recorded in the Jungle Room at Graceland in February 1976 and became a hit in 1977. Both were written by Mark James.
Major global economic events and implications
US economic data was reasonably good. Retail sales rose strongly in July, home builder conditions are solid and benefiting from ever lower mortgage rates and while industrial production fell in July manufacturing conditions in the Philadelphia and New York regions were stronger than expected in August. Core consumer price inflation rose more than expected in July but with weak growth in producer prices and unit labour costs it’s hard to see inflation going up much from here.
Eurozone June quarter GDP growth was confirmed at just 0.2%qoq or 1.1%yoy, but the manufacturing heavy German economy contracted highlighting the drag from fallout from the trade war and slowing Chinese growth. This all reinforces the case for more ECB easing which is likely next month, but also for German fiscal stimulus which is inherently affordable given its budget surplus and relatively low public debt.
Chinese data for retail sales, industrial production, investment, credit growth and money supply for July all slowed more than expected suggesting that the slowdown in the Chinese economy is continuing with the trade war posing an increasing threat. More policy stimulus is likely ahead.
Australian economic events and implications
Good news on jobs but not enough to head off more RBA rate cuts. July saw a solid rebound in employment driven mainly by full time jobs, but rising participation kept unemployment at 5.2% and underemployment rose to 8.4%. Going forward the problem is that slowing job vacancies and hiring plans point to slower jobs growth ahead which means that unemployment and underemployment will remain very high making it hard to see a pick-up in wages growth anytime soon. On the later it was noteworthy that wages growth remained at 2.3% year on year in the June quarter and were it not for the acceleration in minimum wage increases it would be stuck around the 2% or so low seen in 2016.
Its only early days in the June half earnings reporting season with about 27% of companies having reported, but so far the results have been a bit messy. Only 37% of results have surprise on the upside which is below the long-term norm of 44% and 43% surprised on the downside. 63% have seen earnings rise from a year ago but this time last year it was 77%. Likewise, 57% of companies have raised their dividends but this compares to 77% doing so a year ago and 29% have cut their dividends suggesting greater caution. Reflecting the mixed results only 50% of companies saw their share price outperform on the day of reporting. Some retailers surprised on the upwside and were confident about rate cuts and tax cuts boosting spending, but overall results so far point to constrained growth outside resources and a cautious outlook.
Source: AMP Capital
Source: AMP Capital
Source: AMP Capital
What to watch over the next week?
Central bankers likely to be dovish at Jackson Hole. Central bankers and monetary policy will no doubt be in focus over the next week with the Fed’s annual central bankers’ get together in Jackson Hole on 22-24 August. There will clearly be no difficulty filling out the topic which is “Challenges for Monetary Policy” and there is likely to be lots of discussion about continuing low inflation and threats to growth from Trump’s trade wars and what to do about. The minutes from the Fed’s last meeting (Wednesday) are likely to lean dovish (despite being a bit dated given the escalation of the trade war since then) and comments by Fed officials including Fed Chair Powell on Friday and other central bankers at Jackson Hole are likely signal further monetary easing ahead.
On the data front in the US, expect to see a fallback in business conditions PMIs for August (Thursday) on the back of the latest escalation in the trade war, a rise in existing home sales (Wednesday) but a fall in new home sales (Friday).
Eurozone business conditions PMIs for August (Thursday) are also likely to fall, particularly for manufacturing, on the back of Trump’s trade war escalation this month.
Japanese business conditions PMIs will also be released Thursday and July inflation data (Friday) will likely remain soft.
In Australia, the message from the RBA both via the minutes from last Board meeting and from an address by Governor Lowe at the Jackson Hole symposium is likely to be that it remains dovish. Both are likely to repeat guidance that rates will remain low for an extended period and that its bias is to ease monetary policy further. On the data front, skilled vacancies will be released Wednesday and business conditions PMIs for August will be released Thursday.
The Australian June half earnings report season will see its busiest week with around 115 major companies reporting including Sonic Healthcare and BlueScope (Monday), BHP (Tuesday), Brambles, Amcor and Worley Parsons (Wednesday) and Qantas, Origin and South 32 on Thursday which is the busiest day of the reporting season. Consensus expectations are for around 2% earnings growth for 2018-19, mainly due to resources.
Outlook for investment markets
Share markets are at high risk of further short-term weakness on the back of the escalating US/China trade war, Middle East tensions and mixed economic data as we enter a seasonally weak part of the year for shares. But valuations are okay – particularly against low bond yields, global growth indicators are expected to improve by next year and monetary and fiscal policy are becoming more supportive all of which should support decent gains for share markets on a 6-12 month horizon.
Low yields are likely to see low returns from bonds once their yields bottom out, but government bonds remain excellent portfolio diversifiers.
Unlisted commercial property and infrastructure are likely to see reasonable returns. Although retail property is weak, lower for longer bond yields will help underpin unlisted asset valuations.
The combination of the removal of uncertainty around negative gearing and the capital gains tax discount, rate cuts, tax cuts and the removal of the 7% mortgage rate test suggest national average capital city house prices have probably bottomed. Next year is likely to see broadly flat prices though as lending standards remain tight, the supply of units continues to impact and rising unemployment acts as a constraint.
Cash and bank deposits are likely to provide poor returns as the RBA cuts the official cash rate to 0.5% by early next year.
The $A is likely to fall further to around $US0.65 this year as the RBA cuts rates further. Excessive $A short positions, high iron ore prices and Fed easing will help provide some support though with occasional bounces and will likely prevent an $A crash.