2019 – Another year of growth underwritten by Central banks
You may recall at the end of 2018 we saw a large correction down in the S&P500 of around -20% as investors in US shares sold out on fear of rising rates and slowing growth. Enter the US Federal Reserve with a change in monetary policy from tightening (raising rates) to loosening policy (dropping rates).
Interest rates in US and around the globe fell, however the world continued to slow with the global Purchasing Manager Index (PMI) moving into negative territory around the world. This caused share markets in most developed economies to move sideways on the uncertainty around whether we would see the US China trade war leading to the developed economies moving into recession.
Economists were forecasting that in August 2019 Quantitative Easing would end with a net $10 billion per month being removed from the markets. As the world continued to slow however Central Banks again rode to the rescue and the QE forecast changed with November 2019 forecast US$100 billion per month being pumped into the markets in a continued effort to stimulate economies.
This new stimulus from most central banks has led to an increase in China’s orders which as shown above is expected to see global PMI move back above 50 and back into growth territory. Indeed, we are already seeing green shots in Europe and China with global developed share markets moving higher late-November on the back of better than expected growth numbers.
Global growth is a good sign isn’t it?
So, is this the end of concerns around a global slowdown? Absolutely not! Total global debt (government, financial and private) is forecast to reach US$255 trillion by the end of 2019. This is up from US$100 trillion in 1999.
US corporate debt is now up from $4.5 trillion in 2000 to nearly US$10 trillion in total today, a new record. The cost of funding this debt is currently at close to record low levels, but as growth expectations rise so might the borrowing costs which could lead to another cycle lower for global growth.
We have already seen the US 10-year bond rate move from its low of 1.46% in September 2019 to around 1.90% in November. This may not sound like much of a move, but it reflects a 4% reduction in the value of the bond if you purchased it in September 2019. When interest rates are this low seemingly small interest rate moves are meaningful.
What about the US share markets?
The economic cycle that the US is currently experiencing on the back of all this stimulus is now officially the longest growth cycle in US history (125 months). Interestingly, while it is the longest cycle in history it is also the slowest recovery in US history with only 2.3% annualised growth to the end of October 2019.
As US share markets pushed higher most foreign investors became net sellers of US shares, as were pension and mutual funds. So, who was buying all the shares? As shown in the left chart below share buy backs (corporates use cashflow to buy their own shares back) have been happening at record levels in 2018. Indeed, corporations are now using more than 100% of their free cashflow meaning they are borrowing to allow them to continue to buy shares and pay dividends to support share prices at this level.
While it may seem impractical for a corporation to borrow money to then pass onto shareholders, we have seen this sort of behaviour before in both the 1990’s (ending in the tech wreck) and 2006 to 2008 (ending in the GFC). In both these examples corporations continued this behaviour for almost 3-years before markets finally sold off.
Given this, and the record low interest rates that corporations can currently borrow at we may see this sort of behaviour continue for the next few years. However, given the unsustainable nature of this approach we continue to recommend clients remain cautiously positioned in the growth sector.
So, is a recession imminent in the US?
Market expectations of a US recession within the next 12-months are starting to drop into the end of 2019, reducing from just over 50% to c.25%. Share and bond markets are driven on expectations. With Google searches on “chance of a recession” at an all-time high
most economists continue to predict a slowdown in GDP growth and a 35% chance of a recession within the next year or two.
Using the Google search of “chance of a US recession” as a comparison, in 2016 this search spiked just after the US yield curve inverted, with markets and economists then were forecasting a 35% chance of a recession in the US in 2017. They were wrong then and may well be wrong again now.
This ongoing price inflation amidst recession fears doesn’t mean there will or won’t be a recession. Although it does mean that if asset price inflation continues to increase despite global growth declining it may lead to countries moving into stagflation, which has historically been very bad for share markets.
There continues to be many dark clouds on the horizon, such as the US China trade talks, the US elections, or the continued rise in populist parties leading to a break down in globalisation, but there have been dark clouds before, and so long as the central banks continue to underwrite risk with further QE we will continue to see a disconnect from the market fundamentals.
Below we have included a chart showing the previous five worst drawdowns of US shares. As you will note the Tech Wreck and GFC were two of the worst by a large margin with both falling by 45% to 50% vs. the other three corrections of 20% – 30%. It is important that investors understand that this or even a greater fall is a real possibility for the share markets and prepare their investment strategies and portfolios accordingly.
NZ economy continues to slow
Given New Zealand is a trading nation, as our trading partners economies have slowed, so have we. NZ’s Gross Domestic Product (GDP) has slowed from around 4.9% in late 2014 to a forecast 2.2% for 2019. On the back of this we have seen the RBNZ cut rates twice. The reduced by 0.25% in May 2019, and a surprising 0.50% in August 2019 to try to stimulate the economy. Most local economists are picking between one and two more cuts in 2020. This could take the NZ OCR as low as 0.50%.
NZ Banks tighten lending practices
If you have tried to get lending from a bank in the last 12-months you may have noticed it has become very difficult, with the banks becoming much most selective in who they give mortgages to. As shown below credit availability has reduced markedly across all areas of lending, but especially Commercial, Agri, and Corporate lending. We have also had anecdotal evidence from some brokers we deal with that it seems to be as difficult to get borrowing now as it was during the height of the GFC. If this does not change in 2020 this will be a major drag on New Zealand’s growth prospects.
This has been driven by several different factors but the two of the main culprits are:
- concern around the new capital adequacy rules that the RBNZ is releasing on December 5th. It is expected that banks will be required to raise a large sum of funds to increase the capital they are carrying versus their debt. They will have 5-years to meet the new requirements, and this is expected to lead to a further tightening on lending and potentially a rise in interest rates.
- the funding gap between the amount banks are holding in term deposit and the sum they are lending (chart above). As interest rates have fallen on term deposits funds have flowed form the banks TD’s into alternative investments with higher yields. This is left a large funding gap that the local banks fill from offshore markets. The RBNZ does not like this approach as it opens the NZ banking system up to more global risk, hence we may see further tightening on lending, and maybe TD rates rising to attract investors back and reduce this gap. This will likely lead to higher mortgage rates.
Given the reduction in interest rates in NZ over 2019 we have seen bank mortgage rates drop to new record lows, which has led to a revival in borrowing for residential property. As shown above this is one sector of the banks lending that is still not tightening and hence, we are seeing a revival in the residential property market as sales increase into the end of 2019.
As shown below Westpac’s economics team are forecasting an increase in property prices into 2021 and 2022 before property price inflation starts to flatten again. Any further tightening in lending or increase in mortgage rates for reasons discussed above will likely end this next growth cycle sooner than forecasted.
One of the more interesting charts from Westpac’s recent market update was the updated numbers around regional population growth. It appears that the assumed high growth in Auckland’s population was very overstated, with forecasted growth of around 14% over the past 5-years but actual growth only being c.8% with the other regions receiving most of the population growth. Why does this matter? Because that housing shortage that you hear about in Auckland may not be as bad as some market commentators (and all realtors) have been saying and the gap required to meet demand may be met sooner than most have forecast.
So where to from here?
Most of the central banks around the world have failed in their efforts to increase inflation back to their targets. They are now commencing their efforts to push interest rates lower and retain liquidity in markets with the US Fed, Bank of Japan and European Central Bank pumping in more stimulus.
As discussed previously there is potential for GDP growth to improve in 2020 which may see share markets increase on the back of continued quantitative easing, but it is becoming more apparent that this may not lead to higher inflationary pressures. The next options governments and central banks have are borrowing further funds to:
Start purchasing more corporate bonds (vs. government bonds) to put further downward pressure on interest rates – unlikely to work given the BOJ and ECB are already doing this;
Start purchasing shares to put downward pressure on risk premiums as we have seen in Japan – unlikely to work given many people don’t own shares and don’t benefit from this;
Start fiscal spending via wide individual tax cuts and the creation of large infrastructure projects – this may work and increase inflationary pressures over the next 2-3 years.
There are reasons that share markets may continue to rally, but the reality is we are now in the longest bull market in history with record high levels of debt, and interest rates at record low levels. Assets remain overvalued on a historic basis, however we remain cautiously invested as it is never a good idea to beat against the US Fed.