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Mark Kiely, Portfolio Manager, Antares Fixed Income
The global economy has come a long way in the ten years since the global financial crisis (GFC). While the US looks to have recovered, and as our memories of the past fade, we’re at risk of forgetting the calamity of the GFC - which is dangerous as there are signs of headwinds on the horizon. There’s weakness in China, and slowing growth in Europe, and it’s forcing a re-assessment of risk levels and whether the current growth cycle is nearing its end.
Is it headwind, or a storm?
Growth data from the US is strong, but it’s dangerous to become complacent, and it’s necessary to look ahead to assess the risks. Starting with the good news: US gross domestic product (GDP) growth is healthy at 3.5%, unemployment is low at 3.7% and inflation has stayed in-line with the Federal Reserve’s (Fed’s) target of 2% for the last five months in a row.
Looking deeper, it appears US growth is not as broad-based as it has been in the past. Household spending has been driving most of the current growth and that’s not likely to be sustainable. It’s been driven by the ‘sugar hit’ of rising asset prices and tax cuts, and that stimulus is fading. It’s inevitable that so much growth will lead to rising mortgage rates, and the impacts of that have already been felt in the housing sector and auto sales.
The recent US GDP data also showed a weakness in business spending and exports, suggesting the peak in stimulus from government spending is behind us, and soft pockets of global growth (particularly China, emerging markets and Europe) are likely to be a drag on the US economy.
This is compounded by US policy uncertainty, especially around trade and tariffs, along with rising geopolitical tensions. All of which will play on the nerves of corporate managers and investors who may hold back on capital expenditure and doing major deals.
Is this a sign of a major downturn? Or just a correction?
It’s too early to tell, but the question is key to whether this growth momentum can be sustained. Important to note at this juncture is that stronger growth will most likely be met by additional tightening from the Fed (through higher interest rates), and this has the potential to weigh on any market gains. It’s a balancing act, but it would most likely take a big hit to asset prices before the Fed slowed the rate at which it’s raising interest rates.
Where inflation is heading is becoming very important in this environment. It currently looks subdued, but if growth continues, increasing prices and wages have the potential to be a further driver for the Fed to push rates higher.
Rising bond yields contribute to this financial tightening, and higher yields are likely to put downward pressure on stock prices. This equity market weakness would be an additional weight on the economy.
The Fed will turn the dial on rates to slow price rises and put the brakes on a runaway economy, but in the past this intervention has gone too far and this has been the well-documented catalyst for many downturns.
How to put the brakes on, without having a crash
History demonstrates how difficult it is to slow a growing economy, and while the US has gone the furthest in withdrawing liquidity, via the tightening of interest rates and withdrawal of quantitative easing, other regions across the globe are following suit.
Emerging markets have been hit by the effect of a strengthening US dollar while elsewhere economies are being impacted as governments wind back the spending policies they implemented in the wake of the GFC.
The largest source of recent stimulus came from President Donald Trump's fiscal (tax and spending) policies, which are peaking with a 1% contribution to growth. These are set to fade over the next year. Stimulus packages in Canada and Japan also provided a significant boost to growth a couple of years ago, but that has passed. Fiscal policy is now a modest drag in Japan. In Europe, the end of debt crisis austerity saw a shift toward more spending and lower taxes, providing a lift to growth that peaked earlier this year, but that fiscal expenditure too is now starting to fade, outside of Italy.
Growth in Australia has followed the trend of the US, albeit at a slower pace. Australian GDP growth sits at 2.8%, unemployment is at 5% and inflation is 1.9% (just below the Reserve Bank of Australia’s target range of 2% - 3%). Not too bad, but there are also many reasons to be concerned that the good times won’t last.
Tensions are rising as the US attempts to slow the rise of China’s economic and military power, and Australia is likely to find itself wedged in the middle. The US is our biggest defence partner and China is our biggest trading partner. If trade barriers go up, and the Chinese economy falters, then Australia will suffer.
In the past the Australian dollar has been a reliable buffer to financial pain. Currency depreciation has acted as a cushion to any trade dislocations. While a hit to the Aussie dollar might make a trip to New York more expensive, it offers a huge boost to local exporters and it keeps GDP ticking along. The question is, will it be enough this time around?
Global headwinds are one thing, but what most Australians are focussed on is the very real slowdown in the housing market. This comes amid very high levels of household debt, as well as stagnant wage growth and tighter credit conditions.
On top of this, savings rates are at a very low 1%, which means households lack a buffer to rising interest rates. Recently we have seen some out-of-cycle Australian mortgage interest rate rises and as a result there has been some signs of mortgage stress. This is concerning given the current low interest rate environment and shows that Australian households have a high sensitivity to rate rises.
On the whole it suggests that Australia might not be as economically resilient as one might hope.
While a recession may not be imminent there is certainly a case that risks appear to be building; risks that in time may curtail the continuation of the current global economic expansion. It’s worth considering that after ten years of growth (since the GFC) the current cycle of global expansion may be in its final stages.
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