The battle begins
Central banks around the world have started cutting rates. The Fed – the most important central bank globally – cut the Fed Funds rate by 25bps to 2.25% in early August. Fed Chair Powell positioned the rate cut as an insurance cut. The prospect for more cheap liquidity had reduced the equity risk premia and bumped equity prices higher.
But the global economy is slowing. Significant parts of the global economy are already in industrial recession. Political uncertainties including global trade disputes leave risks skewed to the downside. The battle between cheap liquidity on one hand and rapidly deteriorating fundamentals on the other is about to heat up. There is still time for investors to prepare and protect their portfolios from significant downside risk. But the time to act is now.
Central banks take it easy
Developed and emerging market central banks have been cutting interest rates over the past six months (Figure 1). Rate cuts have been in response to deteriorating economic growth, stubbornly low inflation, and elevated uncertainty surrounding ongoing global trade disputes.
Figure 1: Central banks have cut interest rates and are likely to cut further
Developed economy bond markets are priced for more rate cuts. Australian 10-year government bond yields have fallen to the lowest level in history (Figure 2). US 10-year Treasury bond yields have continued to trend lower. German 10-year bund yields and Japanese 10-year government yields are among the more than $12trillion of global debt with negative yields.
Figure 2: Sovereign debt yields have pushed lower in 2019
The Fed positioned its cut as insurance against global downside risks. Interest rate markets are expecting deeper cuts from the Fed. Similarly, Australian rates markets are expecting deep cuts from the RBA. We agree. Our base case view is both the Fed and the RBA will be forced into QE over the next 18 months. We think the prospect for increased cheap global liquidity has been a key driver of the rally in equity markets this year.
Economic fundamentals and liquidity will battle it out in the equity market
While the US economy is still growing, forward-looking indicators are flashing warning signs. Both the services and manufacturing PMIs – strong leading indicators of the growth outlook – are heading rapidly towards levels consistent with recession (Figure 3).
Figure 3: US PMIs have moved quickly toward 50 – the level separating expansion from contraction
We think Europe, Japan and Australia are already experiencing an industrial recession. We expect this to broaden to a full recession at some stage over the coming 18 months. Earnings growth has slowed already across these and the US markets. The fundamental outlook is not positive.
But equity markets have been able to ignore this as the prospect of sustained policy easing has increased valuations. We think the battle between fundamentals and cheap liquidity will become increasingly fierce over the next 18 months.
We will see it in the equity markets. Already, the US S&P500 has experienced increasing episodes of volatility since 2018 (Figure 4). This is likely to continue. The journey for those investors with large exposures to equity will be increasingly uncomfortable.
Figure 4: Equity market volatility has been spiking higher – and that is likely to continue
Who will win the battle? One of our investment beliefs is that fundamentals will drive market outcomes over the medium-term. Investors should take the opportunity now to begin preparing.
Now is the time to prepare
The battle between economic fundamentals and market liquidity is heating up. Market volatility looks set to increase over the next 18 months. Investors with large exposures to equities should brace for an uncomfortable journey. More broadly, most investors are likely to find it harder to achieve their required rates of return as a result. There is still time to prepare for the challenging outlook. But now is the time to do so.
Contact Oreana Financial Services or your affiliated Advisor to find out how we can assist with managing your wealth.
Data sources: Bloomberg LP, Oreana Financial Services