Recession risks on the rise
Rising interest rates and a global trade war are threatening to dampen world growth, heightening risks of a downturn. Is it time for Australian investors to start battening down the hatches?
Rising interest rates and a global trade war are threatening to dampen world growth, heightening risks of a downturn. Is it time for Australian investors to start battening down the hatches?
Global economic growth is seen climbing to 3.9 per cent this year and next, up from last year's 3.7 per cent, as the global cyclical upturn enters its second year, according to the International Monetary Fund (IMF).
However, the IMF sees growth peaking in many nations and becoming less synchronised as the global upturn enters its second year. Its latest World Economic Outlook Update released in July cut its projections for the Eurozone, Japan and Britain, while warning of risks to emerging markets amid trade tensions and rising US interest rates.
A narrowing gap between short and long-term US interest rates could also signal increased risk of a recession, according to a recent study by researchers at the San Francisco Federal Reserve Bank.
The study added to other measures showing a flattening yield curve, suggesting that "recession risk might be rising," the report said.
Historically, each time the yield curve inverts with short-term rates rising above long-term rates, "a recession follows".
The study found no immediate sign of a recession, with long-term rates still above shorter-dated debt. Nevertheless, other indicators are also flashing red.
For the first time since the global financial crisis, premiums on the lowest-rated investment-grade US bonds have risen to 2 per cent over US Treasuries. A 2 per cent credit spread has emerged prior to "six of the past seven recessions," according to the Leuthold Group.
The Fed is widely expected to continue its policy "normalisation" by hiking interest rates further, with markets pricing in a 90 per cent chance of another 25 basis-point increase at the next policy meeting this month.
This would raise the official target range to 2 per cent to 2.25 per cent, still "providing oxygen for the equity markets," according to Morningstar’s head of equities research, Peter Warnes.
However, Warnes warns of a US downturn ahead because of the clash between restrictive monetary policy and expansionary fiscal policy, along with global trade tensions.
"These trade tensions, if left unchecked, have the potential to trigger a global economic recession within the next two years," he says.
Should China suffer the effects of the US trade war, the world's two largest economies could start slowing at exactly the same time, dragging down the global economy and Australia with it.
Trade tensions, if left unchecked, could spark a global recession
Rate hikes bite
Capital Economics suggests rising US interest rates are starting to weigh on the world’s biggest economy.
"Real interest rates are still relatively low, but the cumulative increase in the real two-year Treasury yield over the past couple of years (and particularly the past 12 months) is no longer that far off the tightening that preceded the three previous economic downturns," chief US economist Paul Ashworth said in a 29 August report.
US housing sales "now appear to be on a downward trend," with mortgage, credit card and other loan rates hitting new highs.
With the effects of the fiscal stimulus seen waning next year and monetary tightening becoming more pronounced, the London-based consultancy predicts US GDP growth will slow to 2 per cent in 2019, "with the risk of a more severe slowdown in 2020".
Accordingly, Capital Economics sees the longest bull market in US equities ending in 2019, amid faltering profit growth at home and abroad. The Fed is therefore expected to "call time" on its rate-hiking cycle in mid-2019, paving the way for interest rate cuts "by early 2020".
Elsewhere, the Bank of England has tightened policy along with the Bank of Canada, while the European Central Bank (ECB) has announced plans to end its massive bond-buying program.
However, economists have a mixed track record on predicting recessions. The Fed’s slow pace of monetary tightening reflects the cautious approach of central banks following the GFC, with the ECB reluctant to tighten policy too quickly and Japan still adopting ultra-easy policies.
Australia has enjoyed a record-beating 27 straight years of economic growth and economists see this continuing a while longer, barring a large fall in house prices or a credit crunch, as previously noted by Morningstar.
Cash and other safe havens
Yet with the warning signs increasing, Morningstar’s Warnes has urged investors to increase cash holdings to provide "optionality" should asset prices suddenly fall.
It's a sentiment echoed by Morningstar chief investment officer Andrew Lill.
"Clearly, cash is not an asset that a long-term professional investor wants to have in their portfolio forever; however, cash does have two great advantages going for it," Lill says.
"Number one is that liquidity and optionality to invest quickly when markets become dislocated and there's a great opportunity to invest overnight.
"And two, right now, even though most investors are chasing those returns of the equity markets, in general, the reward that you get for taking investment risk is much lower than it has been for the last decade."
Another option could be considering some "insurance" in the form of exchange-traded funds that profit from a downturn, such as the BetaShares Australian Equities Strong Bear Hedge Fund (ASX:BBOZ).
And as Morningstar suggests, selecting stocks with economic moats capable of sustaining excess profits over a long period provides another safety margin for investors.
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Anthony Fensom is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria. The author does not have an interest in the securities disclosed in this report.
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