One of the most interesting tug of wars we have seen in recent history is between the US share market which keeps pushing close to new record highs and the US money market, which is consistently warning of a recession.
Surely, they can’t both be right?
The inverted yield curve in the US – in which long term interest rates fall below shorter term rates (usually 10 years versus three months) – has previously been quite an accurate predictor of US recessions.
Even apart from that inverted yield indicator, which has continued to periodically flash an amber warning, the US economy has now grown for 10 years straight which matches the tech bubble period of March 1991 to March 2001 as the longest period of US economic expansion since the Great Depression.
Long expansion causes worries
Even on a historical basis you would think that the odds of a US recession – and the significant global ramifications that would flow from that – are starting to shorten dramatically.
That is particularly the case as the US pursues an aggressive and somewhat baffling and intractable trade war with its biggest trading partner in China – a trade war that may have been much easier to enter than it will be to exit now that both sides have really dug in.
At the same time as all of this is happening, the US share market as measured by the S&P 500 index continues to rise towards record territory – a feat which has been reflected in a more muted way on the Australian and many other international share markets.
Lower rates cause further share rally
The latest market rally has been driven by signs that the US Federal Reserve will act to cut interest rates should the trade war threaten to cut US economic growth.
US and international investors – including the many Australian investors who are active in the giant US market – took significant heart from that announcement and again pushed shares higher.
So, who is right?
Is the US – and by proxy the rest of the world – getting set for a nasty recession?
Or is the share market right and the US economy is performing well with corporate profits set to keep rising and more stimulus from the Fed on the way?
It probably seems absolute lunacy but it is possible that both camps are at least partly right and that the US economy will “muddle through’’ a period of slowing growth and that owning stocks might be a rational decision.
Then again, the future is always unpredictable and anyone who claims to know what will happen on financial markets in the future should not be trusted.
This time it is different
The phrase “this time it is different’’ is now enshrined in history as a sure sign that a bubble is about to burst.
But could this famous excuse for continuing to invest even when the warnings signs are clearly visible actually be accurately applied to the situation the US market – and by default all other major markets – find themselves in at the moment?
It might seem a stretch but, in many ways, we haven’t been in a situation quite like this before.
Boom and bust replaced by muddling along
Following the GFC and the extraordinary period of money printing stimulus by central banks around the world, the predicted response would have been a massive boom as the stimulus funds were employed and inflation roared away followed by a massive bust.
That hasn’t really happened.
Even in the US, which eventually recovered quite nicely from the dark days of the GFC, economic growth rates have been steady but unspectacular and certainly far from absolute boom times.
And inflation has been curiously absent, with price rises remaining muted as spare capacity in the major economies remains in place.
It is a similar situation in Australia with growth rates remaining muted and well below the long term trend growth before the GFC.
Central banks move back to cutting rates
When central banks such as the US Federal Reserve started to put up interest rates to bring in the punchbowl while the party was still going, markets got spooked and economic growth began to stall.
Here in Australia it was not that long ago that the Reserve Bank had a bias towards raising interest rates – now has cut them to a record low of 1.25% and there is every possibility of another cut.
Even the developing world, which normally grows faster than developed world economies, seems to have had the brakes applied and is locked in a cycle of slower growth, lower inflation and relatively lower interest rates.
As for why things are different this time, there have been many theories ranging from technology producing productivity efficiencies and replacing jobs on a large scale all the way through to the changes in world trade away from a relatively free and open trading system back to bilateral deals and rising protectionism in the form of tariffs.
Could it also be that we are running out of populous developing countries that are happy to provide low paid jobs and export their way to greatness as countries like China and many others work to climb the value chain and get out of low value manufacturing?
Whatever the answer, the fact that things do seem to be different this time makes investing particularly challenging.
Yields are so tiny
One of the biggest problems about investing at the moment is that fixed interest yields are so tiny that they are almost non-existent.
Even if you stick to government bonds but go up the risk curve and into developing countries, yields remain compressed and currency risk makes such adventurism difficult to justify.
Bonds as an asset class have enjoyed a bull market even more spectacular than the one in shares, with the result that bond yields have shrunk remarkably.
Again, the price of entry and safety is perhaps harder to justify than at many other times – how is it possible for bonds to rally from here?
Many bonds are now on negative yields
Indeed, bonds have rallied so far that it is estimated that US$11.5 trillion of government bonds are now trading on negative yields – that’s right, you actually pay governments to store your money in the form of their bonds.
Here, in Australia, term deposit yields are becoming almost trivial and represent a very high cost in terms of missed opportunities – albeit with the benefit of absolutely no risk of loss.
By contrast, shares look much better with dividend yields often a multiple of deposit rates – although the old adage that if something looks too good to be true, perhaps it is, might apply.
With central banks around the world once again talking about providing further stimulus to support economic growth, perhaps risk assets such as shares is the right place to be?
It is a tough conundrum but it seems things really might be different this time.
Although given the rise in the price of that “barbarous relic’’ of gold over the past week, perhaps they are not quite as different as we imagine.