The malaise affecting equity markets and risk assets generally has shown no let up with Australian shares slipping into bear market territory at the end of Feb 2016 (defined as a 20% or greater decline from the most recent high). In some ways it is reminiscent of 2008 with tightening credit markets, bank shares under pressure and worries central banks are powerless.
From their highs last year to their latest lows US shares have now had a fall of 13%, Australian shares -20%, Japanese shares -25%, European shares -26%, Emerging market shares -27% and Chinese shares -49%. So Australia is not alone – in fact the drivers of the fall from last year’s high are global and many markets have had deeper falls. With global growth worries likely to linger we could still see more downside in the short term. However, a critical differentiator between whether that further downside is say 5-10% and short versus say another 25% and drawn out is likely to be whether the US/global economy has a recession and whether central banks can provide more helpful policy support.
What started in January as mainly China based worries has clearly broadened back out to concerns about global growth. At its core there are five fault lines running through the global economy. The first is the malaise in emerging markets that began earlier this decade, with Brazil and Russia in recession. The second is the ongoing concern about China and its intensions regarding the value of the Renminbi. The third is the collapse in commodity/oil prices which is weighing on energy producers and hence business investment, credit markets and driving selling by sovereign wealth funds. The fourth is the strong $US which has made the fall in the oil price worse, raised debt servicing concerns in the emerging world and weighed on the US economy. Finally, there is fear itself as financial market turmoil drives fears that this will cause a global recession (via reduced confidence, lower wealth and tighter credit conditions) which in turn is reinforcing selling pressure and pushing share markets even lower. Worries about banks – and their exposure to energy loans & higher bad debts if there is a recession – seem to be at the centre of this.
These are all feeding on each other to a degree. However, there are some positives: Chinese economic data has been more mixed rather than negative lately; the Renminbi has settled and the $US looks to have peaked; and central banks are becoming more dovish. But I think there are three key issues. How serious is the problem regarding banks? Will the US have a recession? And are central banks out of ammo?
While the risks have risen, there are several reasons for believing that a GFC style credit crisis is unlikely. Banks are better capitalised now, US and European bank exposure to energy loans at around 2-4% of total assets is a fraction of their exposure to housing loans (at the centre of the GFC), new restrictions on proprietary trading have limited banks’ exposure to riskier corporate debt and the issues of low transparency and complexity that bedevilled the sub-prime mortgage market are not really an issue in corporate debt markets now. So far we are not seeing any blow out in interbank lending rates.
This is a critical question as the US share market sets the direction for global shares including the Australian share market and the historical experience tells us that slumps in shares tend to be shallower and/or shorter when there is no US recession and deeper and longer when there is (eg the tech wreck and GFC). See the next table.
Falls in US shares greater than 10% since 1989
Bear markets highlighted in black. Source: Bloomberg, AMP Capital
A range of considerations have raised the risk of a US recession: December quarter GDP growth slowed sharply; credit spreads (ie, the interest rates on corporate bonds relative to government bonds) have blown out to levels associated with recessions; and falling energy related investment is weighing on manufacturing. But against this:
Source: Thompson Reuters, AMP Capital
Source: Thomson Reuters, AMP Capital
The US yield curve is far from inverted
Source: Bloomberg, AMP Capital
We would put the risk of a US/global recession at around 25%.
This is a common concern with interest rates already at or around zero for major central banks. However, they are a long way from being unable to do anything: the Fed can reverse last year’s interest rate hike and launch another round of quantitative easing; the ECB could provide more cheap short term funding for banks; both the ECB and Bank of Japan could expand their quantitative easing programs; and quantitative easing programs could be focussed on buying corporate debt to bring down corporate borrowing rates. More negative interest rates are also an option but central banks may be wary of this after the negative impact of Japan’s move on banks. Perhaps the ultimate option is for central banks to provide direct financing of government spending or tax cuts.
If credit markets and bank share prices don’t settle down soon many or all of these measures are likely to be adopted with the ECB potentially launching a QE program focussed on buying corporate debt as early as next month.
Meanwhile, the People’s Bank of China (with an official benchmark rate of 4.35%) and the RBA (with an official cash rate of 2%) still have a long way to go before they even have to consider unconventional monetary policies.
Times like the present are very stressful as no one likes to see the value of their investments decline. Investors need to allow for several things though:
Aust shares offering a very high yield versus bank deposits
Source: RBA, Bloomberg, AMP Capital
Dr Shane Oliver
Head of Investment Strategy and Chief Economist
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