Image by Ingram Pinn. Source: Financial Times, 6 April 2018
There has been no let-up in the flurry of economic and geo-political noise and, if some social media scribes are to be believed, ‘fake news’. This backdrop has heightened financial market uncertainty and volatility. It has also resulted in many pondering if the loss of economic momentum and a normalisation of interest rates (from currently very low levels) will inevitably lead to a recession, most particularly in the US.
With the US Federal Reserve (the Fed) continuing to steadily hike rates, albeit at a moderate pace, it appears the days of easy monetary conditions are over. The general market expectation today is that the impact of economic tightening will not lead to a significant cooling of the US economy until late 2019 or 2020. That said, equity markets typically react to a prospect of an economic downturn some 12 –18 months beforehand.
As we can see from the following chart, there is a continued strong correlation between economic growth and equities. However, it is difficult to identify if one series is any more reliable than the other as a lead indicator. With inflation still not threatening, and the Fed still not aggressive in its tightening phase, the US outlook looks benign ... for now.
The momentum of poor domestic growth means that fiscal or monetary stimulus will likely be required if China suffers a sudden export shock. The recent sharp escalation of protectionist action between the US and China clearly raises the risk of such a shock.
Chinese President Xi does have some economic firepower under his belt, with financial authorities able to ease restrictions on the banks or encourage a weaker Yuan to help boost exports. This would be an apparent outcome should the trade tensions with the US escalate.
After four consecutive months of below average employment, we saw 50.9 thousand jobs added in June. This was the largest net addition since November 2017, and lifting the yearly average from 2.5 per cent to 2.8 per cent. Leading indicators also point to ongoing stable employment growth in coming months. Yearly employment growth looks set to average around 2.5 per cent over the remainder of 2018.
The favourable outlook was reflected in the minutes of the July RBA Board meeting, which noted that members still expected a “gradual decline in the unemployment rate”. Furthermore, “stronger labour market conditions and growing skills shortages” are expected to lead to wages growth picking up over time. However, following the application of tighter lending standards across the residential property market, a mini-credit crunch is underway. With a high level of indebtedness across Australian households, the RBA is unlikely to raise interest rates in the near term.
Despite employment numbers firming, wage inflation is stubbornly low. This is curbing any ability for a highly indebted household to lift the savings rate from current low levels. Household spending is also unlikely to continue to boost GDP growth.
Inflation is also on the rise but “but not much, and not fast” (RBA, July minutes). The consumer price index is expected to increase from 1.9 per cent in 2017 – 2018 to 2.2 per cent this year.
On the importance of China to Australia’s economic outlook, the RBA recorded in July’s minutes: “China’s slowdown will slowly seep into commodity prices, winding back profit-driven boosts to federal revenues, while a mini-credit crunch will sound the death knell for the east coast stamp duty bonanza.”
With a continued neutral stance from the RBA, supportive employment conditions, income tax cuts and a slow recovery in wages; a good but not great economic outlook for Australia looks the most probable.
The key concern at this point surrounds the timing for the turning point across the prolonged business cycle. Although forecasts for global growth in 2018/2019 remain unchanged, it’s difficult to ignore that the risks for growth are becoming asymmetrically skewed to the downside, whilst the inflationary risks could be tilting higher.
Such risks to equity markets have been to date, fairly evenly balanced. The trade wars appear nowhere near over as Trump has recently upped the ante to threaten China with a tax on Chinese exports worth $200 billion at 25 per cent – compared to previously announced tariffs at 10 per cent.
Monetary policy the world over (lower interest rates) remains supportive of equities and other risk assets, and we expect it will continue for at least another year.
The US business cycle is still intact. There are no obvious excesses that signify the end of the expansion, and fiscal stimulus will likely defer the next recession until 2020, although signals are mixed elsewhere.
Although we have recently de-risked our portfolios to carry a little extra cash to reflect the threat of a trade war, it is still too early to call a top in equities when a recession does not appear obvious for at least another eighteen months across major global economies.
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