Summary of key points

• The recovery in equity markets has continued as we expected, as investors responded to the pause in the tightening of monetary policy by the US Federal Reserve.

• A key question remains: what if the Fed wants to resume interest rate increases and quantitative tight-ening (the effective sale of $50 billion per month of government bonds). It seems more a matter of when rather than whether it resumes this path.

• For the time being and probably most of this year and next, both monetary and fiscal policy are supportive of economic growth as well as financial asset prices.

• They will arguably continue to be so for longer than expected as the Fed may be independent of the US government but in practice it has not proven itself to be independent of Wall Street. This continued indul-gence of financial market desires defers rather than cancels the ultimate day of reckoning in the equity markets, much as we saw in the period 2002 to 2007.

• Equity market momentum measured over the last twelve months is still a negative influence but less so than in the final quarter of 2018.

• The shape of the yield curve, a good forward indicator of recessions and downturns in equity markets, is still fairly flat but has not inverted or turned negative. It is not yet signaling recession or a more severe equity market downturn.

• Risks of a significant global recession in late 2020 or 2021 remain. Recessions are usually preceded by a significant equity market downturn. Falls of 20% or more in equity markets are quite possible over the next three years but seem less likely this year.

• Factors that point to such a recession and equity market sell-off include:

◦◦ Slower growth in GDP and in earnings per share as the effect of the US-China trade dispute im-pacts volumes of trade and global supply chains.

◦◦ Eventual rises in US bond yields driven by the sheer volume of borrowing needed by the US gov-ernment to fund its fiscal deficit. Higher long-term bond yields reduce the value of future cash flows from investments and with it the prices of financial assets.

◦◦ The eventual return to quantitative tightening (QT) by the US Federal Reserve, even if the European Central Bank and the Bank of Japan do not follow suit. The ebbing of the tide of monetary sup – port for asset prices may have paused but it will resume and ultimately drain a lot of liquidity from financial markets, turning, albeit gradually over the next few years. By itself QT may not produce a recession, but it will impact financial asset prices, just as the effects of QE went mostly into asset prices rather than economic growth between 2009 and 2018. It has been estimated (by Gluskin Scheff of Canada) that the cumulative effect of quantitative easing over 2009 to 2016 added 1100 points to the S&P 500 index and a reduction of $US1.2 trillion in the Fed balance sheet from its current level of $4 trillion, would be the equivalent of +2.0% p.a. on the Fed Funds rate which is now at 2.5% p.a.

Historically, in recessions, the Fed has cut its rate by close to 5% p.a.. It does not have this amount of ammunition. Therefore, it may need to contemplate negative interest rates as low as minus 2.5% p.a. with the Bank of Japan and the European Central Bank, which already have negative short-term policy rates, having to go even further.

• Overall, we have increased the probability of a reces-sion in the next 5 years from 30% to 40%. It is now as likely as a continuation of the slow growth recovery.

• In Australia, consumer price inflation is running at 1.8% p.a. while wages growth is just 2.3% p.a. so that real wages are growing slowly at +0.5% p.a. House prices in the major cities have fallen as a result of slower total credit growth which slowed from +4.8% p.a. in 2017 to +4.3% p.a. in 2018. Housing credit growth slowed by more from +6.3% p.a. (arguably too fast) to +4.7% p.a. This may recover as mac-ro-prudential controls on bank lending have been relaxed but there are other headwinds in the form of banks becoming more cautious in credit assessment (responsible lending) in the wake of the Hayne Royal Commission as well as potential disruption to mort-gage broking which is responsible for 59% of all home loan business. Further weakening of house and apartment prices should be expected, with some adverse effect on consumer spending, a major component of economic growth in Australia.

• The export component is also important and some-what fragile. It is narrowly based on a small number of commodities (mainly coal and iron ore) being sold to a single large customer (China) that is having its own slowdown in growth.

• As result of this, the previously optimistic Governor of the RBA has recently indicated a shift from the next move in its rate being a likely increase to a more equivocal stance where a cut is as likely as an in-crease.

• China is growing slower than expected. While this makes a deal on trade between Xi and Trump more likely, it has some important underpinnings. The sudden weakening of growth in late 2018 was due in part to the private sector being hit too hard by policy changes made earlier in the year. These included stronger environmental controls (the private sector in China typically has lower environmental standards than State Owned Enterprises or SOEs) together with tighter control on the financial sector to pull back the spiraling amount of debt (the private sector typical-ly gets more of its finance from the less regulated secondary banking sector). The private sector was hit disproportionately hard and GDP growth has slowed even before the effects of the US–China trade dispute have come into play.

• Chinese authorities have backed away from some of this, emphasizing the importance of the private sector, but it may prove to be too late to offset further signif-icant slowing in the GDP growth rate in 2019. There has been some loosening of monetary policy but there is limited scope for fiscal stimulus with the fiscal deficit at 3% of GDP and government debt above 50% of GDP (even though both of these statistics look like luxury compared with the 5% and 90% of the US Treasury).

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