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Plunging bond yields & weak share markets amidst talk of recession – what does it mean for investors?

Date: Aug 20th, 2019

Introduction

Only last month share markets in the US and Australia were at record highs. But ever since President Trump ramped up the US-China trade war again at the start of August, financial markets have seen a significant increase in volatility. Share markets have had 6% or so falls from their highs to recent lows and bond yields have plunged to new record lows in many countries. This note takes a looks at what is driving the market turmoil, the risk of recession and what it all means for investors.

 

Market turmoil – what’s driving it

The bout of market turmoil we have been seeing this month basically has three inter-related drivers. First, President Trump ramped up the US-China trade war again with another round of tariffs on China. (See Escalating US-China trade war).

Second, Chinese economic data slowed more than expected in July and the manufacturing heavy German economy contracted in the June quarter. This is on the back of weak global data.

Third, economic uncertainty drove more money into bonds pushing bond yields down and driving a further “inversion” of bond yield curves – which is when long-term bond yields fall below short-term yields – leading to more talk of recession.

This all drove share markets down. Of course, the turmoil in Hong Kong, Brexit, tensions with Iran, political uncertainty in Italy and increasing risks that a Peronist government will return in Argentina aren’t helping. Talk of policy stimulus has provided some relief though with occasional sharp rallies in shares.

Australia is not in the trade war but anything that weakens global growth threatens our exports and confidence, so we are naturally seeing bouts of weakness in Australian shares and bond yields just like we did last year when the trade war started.

Reasons for concern

There are several reasons for concern. First, the trade war still shows no sign of letting up. Optimism on US trade talks with China have been dashed several times now, the threat of tariffs on autos remains and maybe China has decided to wait till after next year’s US elections.

Second, the trade war and the twists and turns it takes is weighing on business confidence and it’s hard to make firm investment plans when they may be rendered uneconomic by a tweet from Trump. This is particularly evident in a slump in manufacturing conditions PMIs worldwide. See the next chart.

View larger image

Source: Bloomberg, AMP Capital

Third, it’s been hoped Chinese policy stimulus will offset the trade war for the last year now, but China has continued to slow.

Fourth, inverted yield curves have preceded post-war US recessions so the recent inversion can’t be ignored.

Finally, global and Australian share markets are vulnerable to weakness after roughly 25% gains from their December lows to their July highs left them overbought and vulnerable to a correction. This risk is accentuated as the August to October period often sees share market weakness.

Reasons for optimism

However, while the risks have increased there are several reasons not to get too concerned. First, President Trump is getting twitchy about the negative economic effects of the trade war: he delayed some tariffs last week after sharp share market falls and had a meeting with major US bank heads on share market falls. The historical record shows that US presidents get re-elected after a first term (think Nixon, Reagan, Clinton, Bush junior and Obama) except when there were recessions in the two years before the election and unemployment is rising (think Ford, Carter and Bush senior). Trump would be aware of this. Share markets have regular corrections but major bear markets are invariably associated with recession and so Trump is wary whenever shares take a sharp lurch lower. As a result, our view remains that at some point Trump will seek more seriously to resolve the trade issue.

Second, policy stimulus is being ramped up: with numerous central banks now cutting interest rates and indicating that more cuts are on the way including from the Fed; the ECB looks like it will soon return to quantitative easing; Chinese economic policy meetings indicate that more policy easing is on the way; Germany is reportedly thinking about some sort of fiscal stimulus; and there is talk of more US tax cuts. This is very different to last year when the Fed was tightening, the ECB ended QE and other central banks including the RBA looked to be edging towards tightening.

Third, while the risks have increased, a US or global recession remains unlikely: services indicators have held up well (see the first chart) and the services sector is the dominant part of most major economies; we have not seen the sort of excesses that precede global and notably US recessions – there has been no investment boom, private sector debt growth has been modest and inflation is low such that central bankers have not slammed the brakes on; & monetary & fiscal stimulus will provide support.

Finally, the decline in bond yields is making shares relatively cheap. The gap of 4.8% between the grossed-up dividend yield on Australian shares of 5.7% and the Australian 10-year bond yield of 0.94% is at a record high. Similarly, the gap between the grossed-up dividend yield and bank term deposit rates of less than 2% is very wide. In other words, relative to bonds and bank deposits shares are very cheap which should see them attract investor flows providing we are right and recession is avoided.

View larger image

Source: Global Financial Data, Bloomberg, AMP Capital

But what about inverted yield curves?

Long-term bond yields should normally be above short-term bond yields because investors demand a higher return to have their money locked away for longer periods. But sometimes long-term rates may fall below short rates. This happened briefly in the US in the last week in relation to the gap between 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.

View larger image

Source: NBER, Bloomberg, AMP Capital

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 is not necessarily a reliable recession indicator at present: it can give false signals (circled on the next chart); the lags from an inverted curve to a US recession averaged around 18 months in relation to the last three recessions so any recession may 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, 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 as noted earlier we have not seen other signs of an imminent US recession such as over-investment, rapid debt growth, excessive inflation and tight monetary policy. So our base case remains that a US recession is not imminent.

The Australian yield curve has also gone negative with 10-year bond yields of 0.94% below the cash rate of 1% but the gap between the 10 and 2-year bond yields only just positive. But it’s worth noting that Australian yield curve inversions around 1985, 2000, 2005-2008 and in 2012 were useless recession indicators.

View larger image

Source: RBA, Bloomberg, AMP Capital

What does this all mean for investment markets?

In the short-term share markets could still fall further as trade and growth uncertainties remain and as we go through the seasonally weak months ahead. This could be associated with further falls in bond yields. In fact, further share market weakness may be needed to get Trump to seriously resolve the trade issue (as opposed to just go through another trade talks/ breakdown cycle again).

However, providing we are right and recession is avoided, a major bear market in shares (ie where shares fall 20% and a year later are down another 20% or so) is unlikely and given that shares are cheap relative to bonds we continue to see share markets as being higher on a 6-12 month horizon.

What should investors do?

Since I don’t have a perfect crystal ball, from the perspective of sensible long-term investing the following points are repeating.

  • First, periodic sharp setbacks in share markets are healthy and normal. This volatility is the price we pay for the higher long-term return from shares. After 25% or so gains from their lows last December shares were at risk of a correction.

  • Second, selling shares or switching to a more conservative strategy after falls just locks in a loss. The best way to guard against selling on the basis of emotion is to adopt a well thought out, long-term investment strategy.

  • Third, when growth assets fall they are cheaper and offer higher long-term return prospects. So, the key is to look for opportunities that pullbacks provide.

  • Fourth, while shares may have fallen in value, the dividends from the market haven’t. The income flow you are receiving from a diversified portfolio of shares remains attractive. So for those close to or in retirement the key is to assess what is most import – absolute stability in the value of your investments or a decent sustainable income flow.

  • Fifth, shares often bottom at the point of maximum bearishness. So, when everyone is negative and cautious it’s often time to buy.

  • Finally, turn down the noise. In times of crisis the negative news reaches fever pitch, which makes it very hard to stick to a long-term strategy, let alone see the opportunities.

If you would like to discuss any of the issues raised by Dr Oliver, please call on |PHONE| or email |STAFFEMAIL|. 

 

Author: Dr Shane Oliver, Head of Investment Strategy and Chief Economist

Source: AMP Capital 20th August 2019

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455)  (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

Escalating US-China trade war – triggering (another) correction in share markets

Date: Aug 07th, 2019

Introduction

After a third round of talks made little progress last week, the US/China trade war has escalated badly with tit for tat moves on an almost daily basis by each side. This has seen share markets fall sharply with US, global and Australian shares down about 5-6% from recent highs and safe haven assets like bonds and gold benefiting on the back of worries about the global growth outlook. This note looks at the key issues.

 

What is a trade war?

A trade war is where countries raise barriers to trade with each other usually motivated by a desire to “protect” jobs often overlaid with “national security” motivations. To be a “trade war”, the barriers need to be significant in terms of their size and the proportion of imports covered. The best-known global trade war was that in 1930 which saw average 20% tariff hikes on US imports.

What is so good about free trade?

A basic concept in economics is comparative advantage: that if Country A and B are both equally good at making Product X but Country B is best at making Product Y then they will be best off if A makes X and B makes Y. Put simply, free trade leads to higher living standards and lower prices whereas restrictions on trade lead to lower living standards and higher prices.

So why is President Trump raising tariffs then?

It’s basically about fulfilling a presidential campaign commitment to “protect” American workers from what he regards as unfair trading practices in countries that the US has a trade deficit with – notably China. And he knows this is popular with his supporters but there is also some degree of bi-partisan support for taking on China.

What does President Trump want?

Basically, he wants China to lower its tariffs, allow better access for US companies, end US companies being forced to hand over their technologies and protect intellectual property of US companies. At a high level he wants a reduction in America’s trade deficit with China. Along the way he has renegotiated the NAFTA free trade agreement with Mexico and Canada and the free trade deal with South Korea and is in talks with Europe and Japan. In recent times he has also used the threat of tariffs to get what he wants from countries (eg Mexico in relation to border protection).

Where are we now?

Fears of a global trade war kicked off in March last year with Trump’s announcement of a 10% tariff on aluminium imports and a 25% tariff on steel imports. US allies were subsequently exempted but China was not. On March 22 Trump announced 25% tariffs on $US50bn of US imports from China. These were implemented in July and August. After Chinese retaliation Trump announced a 10% tariff on another $US200bn of imports from China (implemented in September) which would increase to 25% on January 1 this year. The latter was delayed as the talks made progress.

However, following May 5 tweets by Trump, on May 10 the delayed tariff hike from 10% to 25% on $US200bn of imports from China was put in place and the US kicked off a process to tariff the remaining roughly $US300bn of imports from China at 25%. If fully implemented this would take the average US tariff rate on imports to around 7.5%, which is significant (albeit minor compared to the 20% 1930 tariff hikes). See next chart.

Average weighted tariff rate across all products

View larger image

Source: World Bank, Deutsche Bank Research

Along the way, China’s retaliation has been less than proportional, partly reflecting lower imports from the US. The US has also put in place restrictions on dealing with Chinese tech companies like Huawei.

Following a meeting in late June between Presidents Trump and Xi the trade war was put on hold pending a third round of talks. These look to have made little progress and Trump announced last week that from September 1 the remaining $US300bn of imports from China will be taxed at 10% and this may go beyond 25%.

China has responded by allowing the Renminbi to fall below 7 to the $US and reportedly ordering state-owned enterprises to halt imports of agricultural products from the US. The US then named China a currency manipulator (even though basic economics pointed to a fall in the Renminbi in response to the tariffs on its good) which opens the door to possibly further action by the US (eg intervention to lower the $US versus the Renminbi) and potentially a further escalation in the trade war.

At the same time, the US is still considering auto tariffs after a report lodged in February.

What happened to the US/China trade talks?

This has been the third round of trade talks that look to have failed. The timing of the announcement of the latest round of tariffs may also reflect a desire by Trump to force the Fed to ease more as he wasn’t happy with its 0.25% cut last week and to show that he is tougher on trade than far-left Democrat presidential candidates Sanders and Warren. Whatever it is, there is likely to have been a further breakdown in trust between China and the US and China may have decided to wait till after the election.

Ongoing tensions around North Korea, Iran, Hong Kong, Taiwan and the South China sea are probably not helping the issue either.

What will be the economic impact?

The latest round of tariff increases from September 1 would be a big deal compared to last year’s tariffs and see the impact shift to largely consumer goods as opposed to intermediate goods in the first tariff rounds. The 10% tariff could knock around 0.3% from US and Chinese GDP particularly as investment gets hit in response to uncertainty about supply chains. The full 25% tariff could take that to around 0.75% with roughly a 0.2% boost to US core inflation (albeit this would be temporary and looked through by the Fed). This would flow on to slower global growth and lead to less demand for Australia’s exports even though we are not directly affected.

What is the most likely outcome?

At this point, it’s hard to see a way out of the escalating trade war and it risks flowing into other issues as well including around HK, Taiwan, and the South China sea as the US and China slip further towards some sort of “cold war”. However, as the economic impact in the US mounts – so far it’s just been impacting business confidence and investment plans but risks impacting consumer spending too – President Trump is likely to become more concerned. Recessions and rising unemployment have historically killed the re-election of sitting presidents (Hoover, Ford, Carter and Bush senior) and for this reason, we remain of the view that a deal will be reached before the election. President Trump showed late last year that he was sensitive to the impact of the trade conflict on the US share market (as after sharp falls he called President Xi to set up a new meeting). So sharp share market falls may be needed again to get the US and China negotiating. But this means it could still get worse before it gets better – the US share market had a top to bottom fall last year of 20%!

It’s also worth noting that policy stimulus by the Fed and the Chinese government will offset some of negative impact which along with the absence of the sort of excesses (like in cyclical spending, inflation and private debt) that normally precede recessions in the US is why we are not predicting a recession.

What does it mean for investment markets?

Basically, the uncertainty around the escalating trade war is bad for listed growth assets like shares as it threatens the outlook for growth and profits, but positive for safe-haven assets which is why bond yields in many countries including Australia have pushed further into record low territory and gold has increased in value.

Following last week’s highs, global and Australian shares have fallen roughly 5-6%, mainly reflecting concern about the impact on growth from the escalating trade war. Further downside is likely in the short term as the trade war continues to escalate and we are also in a seasonally weak part of the year for shares. This is likely to be associated with further falls in bond yields.

However, providing we are right and recession is avoided, a major bear market in shares (ie where shares fall 20% and a year later are down another 20% or so) is unlikely.

What does it all mean for Australia?

Fortunately, Australians aren’t having to pay higher taxes on imports like Americans, but the main risk is that we are indirectly affected as the US/China trade war drags down global growth, weighing on demand for our exports and leading to unemployment pushing higher than our 5.5% forecast for year end. This all adds to the case for further easing by the RBA (we expect the cash rate to fall to 0.5% by February) and for further fiscal stimulus.

What should investors do?

Times like the present are stressful for investors. No one likes to see their wealth fall and uncertainty seems very high. I don’t have a perfect crystal ball, so from the point of sensible long-term investing the following points are worth bearing in mind.

  • First, periodic sharp setbacks in share markets are healthy and normal as can be seen in the next chart. The setbacks are the price we pay for the higher long-term return from shares. After 25% or so gains from their lows, last December shares were at risk of a correction.

View larger image

Source: Bloomberg, AMP Capital

  • Second, selling shares or switching to a more conservative strategy after a major fall just locks in a loss. The best way to guard against selling on the basis of emotion is to adopt a well thought out, long-term investment strategy.

  • Third, when growth assets fall they are cheaper and offer higher long-term return prospects. So, the key is to look for opportunities that pullbacks provide.

  • Fourth, while shares may be falling in value, the dividends from the market aren’t. The income flow you are receiving from a diversified portfolio of shares remains attractive.

  • Fifth, shares often bottom at the point of maximum bearishness. So, when everyone is negative and cautious it’s often time to buy.

  • Finally, turn down the noise on financial news. In periods of market turmoil, the flow of negative news reaches fever pitch, which makes it very hard to stick to a well-considered, long-term strategy, let alone see the opportunities.

If you would like to discuss any of the issues raised by Dr Oliver, please call on |PHONE| or email |STAFFEMAIL|. 

 

Author: Dr Shane Oliver, Head of Investment Strategy and Chief Economist

Source: AMP Capital 7th August 2019

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455)  (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

The Fed cuts rates

Date: Aug 01st, 2019

As widely anticipated, the US Federal Reserve has cut its key Fed Funds cash rate by 0.25% to a range of 2-2.25%. This is the Fed’s first rate cut since December 2008 and follows nine 0.25% rate hikes between December 2015 and December last year. The Fed also announced that quantitative tightening (ie the process of reversing its quantitative easing program by letting bonds on its balance sheet mature) will end immediately, which is about two months earlier than previously flagged. The Fed’s post-meeting statement left the door open to more cuts although Fed Chair Powell’s press conference confused things a bit (again!) by saying it’s a “mid-cycle adjustment” and “not the beginning of a long series of cuts” but it may not be “just one”.

Taking out some insurance

With underlying US growth still solid and the jobs market tight this should be seen as the Fed taking out some insurance given various threats to the growth outlook including from the US/China trade war, tensions with Iran and slower global growth generally and a greater willingness by the Fed to take risks with higher inflation as opposed to deflation.

So it’s a bit like the easings of 1987 after the share market crash and in 1998 during the LTCM hedge fund crisis when Russia defaulted leading LTCM to go bust, threatening the US financial system.

The pattern of the past 50 years or so is for the Fed to cut rates after some form of crisis threatens the economic outlook. See the next chart. In 2001 it was the tech wreck and in 2007 it was the sub-prime mortgage crisis. This time around there is nothing on that scale although it may be argued that the trade wars are providing the biggest single threat.


Source: Thomson Financial, AMP Capital Investors

This year’s fall in core private final consumption inflation back below the Fed’s 2% target provided the Fed with the scope to move.

Further easing is likely, but it’s likely to be limited

It’s rare for the Fed to just cut once. In the insurance cuts of 1998 through the LTCM crisis it eased 3 times by 0.25%. Given that the risks to the growth outlook – particularly on trade – won’t go away quickly and that the Fed appears to have taken the decision that it’s easier to control a rise in inflation than a further slide or deflation, it’s likely to cut rates further and we are allowing for another cut in September.

However, we remain of the view that a US recession is not imminent (see The longest US economic expansion ever). While the yield curve is flashing warning signs, the excesses that normally precede US recessions are not present. In particular: the US has not seen a spending boom with cyclical spending on consumer goods, investment and housing running around average as a share of GDP; private debt growth has been moderate; and inflation has been low. Consequently, there is no boom to go bust. Moreover, monetary policy had not become tight with the Fed Funds rate never having reached the high levels that normally precede recessions. See the next chart.


Source: NBER, Bloomberg, AMP Capital

As a result, we see this easing cycle by the Fed as being limited to around 2 or 3 rate cuts with the next likely coming in September as opposed to the 4 or so that the money market has factored in.

Of course, the main threats to this relate to US trade wars and tensions with Iran.

The Fed and shares

Falling interest rates are generally positive for shares. They help boost economic and profit growth and make shares relatively more attractive than cash and hence are usually associated with a higher price to earnings multiples. The table below shows the US share market’s response after the first-rate cut following major tightening cycles.  


US recession highlighted in red. Source: Thomson Reuters, AMP Capital

The US share market rose over the subsequent 3, 6 and 12 months after the commencement of 5 of the last 8 Fed easing cycles. The exceptions were after the rate cuts in 1981, 2001 and 2007 which were associated with recessions.

The reaction by the Australian share market is similar, except the Australian share market wasn’t greatly affected by the post-2000 bursting of the tech bubble.


US recessions highlighted in red. Source: Thomson Reuters, AMP Capital

So if we are right and the US avoids a recession in the next year or so then US interest rate cuts should be positive for shares beyond any near term uncertainty (and the initial reaction which has seen US shares fall as the Fed wasn’t as dovish as hoped) and are likely to be higher on a 6-12 month horizon. It is worth repeating the old saying “don’t fight the Fed”. While scepticism is high that central banks with low-interest rates and QE will spur growth, an investor would have made a huge mistake over the past decade betting against them. The key though is that global economic indicators need to start improving in the months ahead.

Implications for Australian interest rates

The directional relationship between the US and Australian interest rates weakened long ago. The RBA started raising rates in 2009 when the Fed held at zero, it was easing in 2016 when the Fed was hiking and this year it started cutting ahead of the Fed. So just because the Fed moves doesn’t mean the RBA will as well! On the one hand the Fed’s easing along with stimulus elsewhere globally should help support global growth which is good for Australia. But it’s probably not enough to change the outlook for the RBA. Our view remains that it’s on track to cut the cash rate to 0.5% by early next year and to some degree the Fed cutting too reinforces that to the extent that the RBA would like to keep the Australian dollar down.

What about the role of President Trump?

President Trump has been highly critical of Fed rate hikes over the past year and has been saying they should be cutting in recent times. Of course, presidents and prime ministers usually prefer lower than higher rates but the issue, in this case, has been more around whether his comments represent a threat to the Fed’s independence, which is necessary to ensure sensible monetary policy as opposed to politically driven moves. In a world of increasing populism, this could become more of an issue. In terms of the role he may have played in the Fed’s latest decision it’s likely that the Fed has made up its own mind but it’s also interesting to note that President Trump’s huge fiscal easing last year likely played a role in Fed hikes last year and now his escalating trade war has played a role in its easing! So, one way or another he had an impact.

If you would like to discuss any of the issues raised by Dr Oliver, please call on |PHONE| or email |STAFFEMAIL|. 

 

Author: Dr Shane Oliver, Head of Investment Strategy and Chief Economist

Source: AMP Capital 01 August 2019

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455)  (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

The Fed cuts rates

Date: Aug 01st, 2019

As widely anticipated, the US Federal Reserve has cut its key Fed Funds cash rate by 0.25% to a range of 2-2.25%. This is the Fed’s first rate cut since December 2008 and follows nine 0.25% rate hikes between December 2015 and December last year. The Fed also announced that quantitative tightening (ie the process of reversing its quantitative easing program by letting bonds on its balance sheet mature) will end immediately, which is about two months earlier than previously flagged. The Fed’s post-meeting statement left the door open to more cuts although Fed Chair Powell’s press conference confused things a bit (again!) by saying it’s a “mid-cycle adjustment” and “not the beginning of a long series of cuts” but it may not be “just one”.

Taking out some insurance

With underlying US growth still solid and the jobs market tight this should be seen as the Fed taking out some insurance given various threats to the growth outlook including from the US/China trade war, tensions with Iran and slower global growth generally and a greater willingness by the Fed to take risks with higher inflation as opposed to deflation.

So it’s a bit like the easings of 1987 after the share market crash and in 1998 during the LTCM hedge fund crisis when Russia defaulted leading LTCM to go bust, threatening the US financial system.

The pattern of the past 50 years or so is for the Fed to cut rates after some form of crisis threatens the economic outlook. See the next chart. In 2001 it was the tech wreck and in 2007 it was the sub-prime mortgage crisis. This time around there is nothing on that scale although it may be argued that the trade wars are providing the biggest single threat.


Source: Thomson Financial, AMP Capital Investors

This year’s fall in core private final consumption inflation back below the Fed’s 2% target provided the Fed with the scope to move.

Further easing is likely, but it’s likely to be limited

It’s rare for the Fed to just cut once. In the insurance cuts of 1998 through the LTCM crisis it eased 3 times by 0.25%. Given that the risks to the growth outlook – particularly on trade – won’t go away quickly and that the Fed appears to have taken the decision that it’s easier to control a rise in inflation than a further slide or deflation, it’s likely to cut rates further and we are allowing for another cut in September.

However, we remain of the view that a US recession is not imminent (see The longest US economic expansion ever). While the yield curve is flashing warning signs, the excesses that normally precede US recessions are not present. In particular: the US has not seen a spending boom with cyclical spending on consumer goods, investment and housing running around average as a share of GDP; private debt growth has been moderate; and inflation has been low. Consequently, there is no boom to go bust. Moreover, monetary policy had not become tight with the Fed Funds rate never having reached the high levels that normally precede recessions. See the next chart.


Source: NBER, Bloomberg, AMP Capital

As a result, we see this easing cycle by the Fed as being limited to around 2 or 3 rate cuts with the next likely coming in September as opposed to the 4 or so that the money market has factored in.

Of course, the main threats to this relate to US trade wars and tensions with Iran.

The Fed and shares

Falling interest rates are generally positive for shares. They help boost economic and profit growth and make shares relatively more attractive than cash and hence are usually associated with a higher price to earnings multiples. The table below shows the US share market’s response after the first-rate cut following major tightening cycles.  


US recession highlighted in red. Source: Thomson Reuters, AMP Capital

The US share market rose over the subsequent 3, 6 and 12 months after the commencement of 5 of the last 8 Fed easing cycles. The exceptions were after the rate cuts in 1981, 2001 and 2007 which were associated with recessions.

The reaction by the Australian share market is similar, except the Australian share market wasn’t greatly affected by the post-2000 bursting of the tech bubble.


US recessions highlighted in red. Source: Thomson Reuters, AMP Capital

So if we are right and the US avoids a recession in the next year or so then US interest rate cuts should be positive for shares beyond any near term uncertainty (and the initial reaction which has seen US shares fall as the Fed wasn’t as dovish as hoped) and are likely to be higher on a 6-12 month horizon. It is worth repeating the old saying “don’t fight the Fed”. While scepticism is high that central banks with low-interest rates and QE will spur growth, an investor would have made a huge mistake over the past decade betting against them. The key though is that global economic indicators need to start improving in the months ahead.

Implications for Australian interest rates

The directional relationship between the US and Australian interest rates weakened long ago. The RBA started raising rates in 2009 when the Fed held at zero, it was easing in 2016 when the Fed was hiking and this year it started cutting ahead of the Fed. So just because the Fed moves doesn’t mean the RBA will as well! On the one hand the Fed’s easing along with stimulus elsewhere globally should help support global growth which is good for Australia. But it’s probably not enough to change the outlook for the RBA. Our view remains that it’s on track to cut the cash rate to 0.5% by early next year and to some degree the Fed cutting too reinforces that to the extent that the RBA would like to keep the Australian dollar down.

What about the role of President Trump?

President Trump has been highly critical of Fed rate hikes over the past year and has been saying they should be cutting in recent times. Of course, presidents and prime ministers usually prefer lower than higher rates but the issue, in this case, has been more around whether his comments represent a threat to the Fed’s independence, which is necessary to ensure sensible monetary policy as opposed to politically driven moves. In a world of increasing populism, this could become more of an issue. In terms of the role he may have played in the Fed’s latest decision it’s likely that the Fed has made up its own mind but it’s also interesting to note that President Trump’s huge fiscal easing last year likely played a role in Fed hikes last year and now his escalating trade war has played a role in its easing! So, one way or another he had an impact.

If you would like to discuss any of the issues raised by Dr Oliver, please call on |PHONE| or email |STAFFEMAIL|. 

 

Author: Dr Shane Oliver, Head of Investment Strategy and Chief Economist

Source: AMP Capital 01 August 2019

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455)  (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

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