The optimism following the trade truce was cut short earlier than expected, with Trump threatening new tariffs of 10% on the remaining U.S. $300 billion of Chinese imports to go into force on 1 September, though there were some backtracking as tariffs on selected consumer items will be delayed to December. The U.S. Federal Reserve (Fed) also disappointed markets with hawkish commentary after a rate cut but other central banks around the world continued to provide liquidity with cuts.
The S&P/ASX 200 has been resilient. At the time of writing, it is down only about 3% over the past month. The U.S. S&P 500 is down close to 6% in the same period. Similarly, the Euro Stoxx 50 is down over 6% and China’s CSI 300 index is down about 5%.
Commodities sold off following fears of a further economic slowdown due to the prolonged trade tensions. Oil remains weak despite Iran sanctions as demand continues to worsen. Iron ore is plunging after holding up strongly relative to other industrial metals over the past year. On the other side of commodities, precious metals continue their rally with gold leading the way.
The Fed’s hawkish commentary immediately resulted in a spike in yields but Trump’s tweet the next day subsequently sent bond yields tumbling to previous lows. The yield curve continues to invert further, with the key 2-year/10-year spread now negative. Bonds performed strongly in this environment, with the Bloomberg Barclays Global-Aggregate bond index returning over 1.9% the past month.
The Australian Dollar weakened again to around 68 U.S. cents as demand for the U.S. dollar safe-haven rose.
Australian employment remains resilient, with strong growth in full employment in recent readings. Inflation also came in better than expected at 1.6% but still well below the target of 2%. Retail sales remained robust, growing 0.4%, and wages also grew at 0.6% for the quarter. However, housing data disappointed as new home sales, building approvals and home loans all fell despite the recent rate cuts.
In the U.S., the employment market remains strong with the unemployment rate hovering at 3.7% and average wages rising 3.2%. Inflation also came in at 2.2%. Despite both of its main objectives being met, the Fed followed through with a 0.25% cut to interest rates as the forward looking industrial and service indicators continued to weaken. In a move that further clouds the economic outlook and raises the likelihood of further rate cuts, Trump announced that a 10% tariff on the remaining U.S. $300 billion of imports from China will go into effect on 1 September. To add to the uncertainty, tariffs on selected consumer items, which add up to about U.S. $150 billion, have now been delayed to December for fear of impact on the U.S. consumer during Christmas shopping season.
Elsewhere, economic data continues to deteriorate significantly. European manufacturing continues to contract with GDP and inflation at anaemic levels. Likewise, Chinese manufacturing remains in contractionary territory, with investment and industrial production figures well below expectations.
Reporting season is well underway in the U.S. and Europe, and just starting to kick into gear in Australia. Results have so far been encouraging, primarily due to expectations having collapsed over the first half of the year. Overall earnings growth in the U.S. was slightly negative in the first quarter and looks likely to be negative again for the second quarter, which means we are already in an earnings recession. The earnings beats may provide some short-term support, however; the expectations for future earnings remain optimistic and remain largely unchanged over the past six months, so caution is warranted moving forward.
Trade tensions have taken a toll on the global economy, with most countries now below trend growth and slowing further. Many countries like South Korea and Singapore are on the verge of recessions, whilst the risk of recession in the U.S. is rising. Globally, central banks are easing in the effort to combat the slowdown, but unless trade tensions are resolved, a recession is likely to occur in the next 12 months. This view is currently being represented in the bond market as the infamous 2-year/10-year U.S. Treasury spread has now inverted.
The bond market sends out its recession signal
Bonds and equities have decoupled for most of 2019. Equities have rallied strongly whilst bond yields have collapsed, the former is usually a sign of a good economy and the latter is usually a sign of a bad one. Now, the bond market sends its clearest warning yet.
The 2-year U.S. Treasury yield is now above the 10-year yield which is a key signal that a U.S. recession is imminent. This inversion has preceded every U.S. recession since the 1950s.
What does an inversion mean? Basically, the market expects shorter-term interest rates to be higher than longer-term interest rates.
Whilst recession and a bear market tend to follow inversions, there is usually a lengthy lag between the signal and the start of a bear market followed by a recession. Historically, it has taken between 8 months and 2 years for a recession to materialise after inversion, likewise, equities have taken up to 22 months to peak.
Furthermore, equities will generally have another strong rally and a new peak, usually recognised as the ‘euphoria’ phase, prior to the start of a bear market. After the last 10 inversions, there was only one instance where the S&P500 did not reach new highs prior to the start of the sell-off.
The inversion is also generally followed by a less popular signal before a steep drawdown; the steepening of the yield curve.
Like the 2-year/10-year U.S. Treasury inversion, the yield curve steepening signal has been a reliable leading indicator for bear markets. Historically, equity market peaks occur 6 to 12 months later. Given the heavy flows out of equities into bonds over the past year and investor sentiment, the usual euphoria is not present and supports the idea of an impending rebound for growth assets.
We may not be close to the cliff’s edge yet
There are some key differences to previous inversion signals that may see this cycle drag on for longer.
Firstly, the yield curve has been nearly flat for years before the recent inversion, caused quantitative easing, and low and negative interest rates. This means that interest rate expectations do not need to be as aggressive to cause an inversion as it has been in past instances. Furthermore, the past few years is evidence that the yield curve can remain flat for a long time, so a steepening of the yield curve may still be some time away.
Secondly, the yield curve inversions have generally occurred only during what is known as ‘bear flattening’. ‘Bear flattening’ is used to describe periods where the yield on the shorter-term bonds rise faster than the yield on the longer-term bonds does. This means that markets are expecting aggressive rate hikes above the longer-term trend, resulting in tight monetary conditions. This is not what has caused the recent inversion. The recent inversion was the result of a ‘bull flattening’, whereby the yield on the longer-term bonds falls relative to the shorter-term bonds. As the name suggests, this has historically been positive for equities.
Given the delay between inversion and new equity market peaks, plus the caveats of a flatter for longer yield curve and a ‘bull flattening’ causing the inversion, investors should not be panicking to the recent headlines.
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This month’s perspective highlights that market sentiment on all asset classes is constantly changing. It is important for us to quickly recognise any threats, to preserve your investment capital or to identify early investment opportunities to maximise any return advantages. At Partners Wealth Group we don’t get complacent with the current state of play and constantly monitor investments and your portfolios.
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