Volatility was a key theme of the quarter. One of the core signals that triggered the volatility was from the bond market where the interest rate on the 10-year US treasury note fell below the 2-year rate.
This is described as an “inverted yield curve” and is unusual because investors in the bond market typically demand higher interest rates as they lend for longer periods. Historically speaking, this is a sign that the bond market considers short term interest rates set by the US central bank, the Federal Reserve, as currently too high and will need to be cut sometime in the future to counter future economic weakness or a potential recession.
US China tensions
Domestically the US economy has actually been showing reasonable growth, with a very low unemployment level. However, the main concern surrounding economic growth is the potential of a full-blown US-China trade war. Recently, tensions between the US and China have been easing with the US delaying the scheduled hike in tariffs (taxes on imports). This could be attributed to President Trump attempting to avoid going into the upcoming US election during an economic recession, and the fact that some of the US’s tariffs actually hurt Trump’s voters. The US Federal Reserve has noted in a recent speech that business investment and exports have both weakened. The impact on Australia’s economy is not likely to be direct, but rather, the cascade effect from lower growth in China and the US.
The effect of the trade-war can already be seen in Germany as its manufacturing and exports have both declined in the last eighteen months. If the US does proceed with a car tariff on the EU, there is a realistic chance that Germany could fall into a recession. This is a huge concern for the EU as Germany is a top trading partner for many EU nations.
The United Kingdom has continued its negotiations to leave the European Union deciding to go to an election over the issue. Irrespective of future events, the delay and uncertainty caused by these negotiations has had negative impacts on the UK and the European Union. In the worst-case scenario of a no-deal Brexit, the UK would fall back onto World Trade Organisation rules, this means tariffs and border checks.
Saudi Arabia – drone strikes
The recent drone strike on Saudi’s oil fields has added uncertainties to the world economy. Although the attack shut down around half of Saudi oil output capacity, it was recovered much earlier than expected. However, if the market is not confident that there will not be another attack, higher oil prices could prevail, hurting oil importing nations.
Global growth and interest rates
As the global growth outlook has slowed, interest-rates have continued to decline with around 30% of the global bond market now generating negative yields. Part of this has been due to the move by many central banks around the world to cut interest rates, including the Reserve Bank of Australia. In aggregate, these lower interest rates help support the global economy. Over the last decade, corporates have been building up their debt levels. In the US, the average quality of corporate debt has declined as investors chase higher returns from riskier issuers. China also has a high level of debt, as state-owned banks previously lent money to other government branches to stimulate its economy. In a scenario of a full-blown trade war, these pockets of excessive credit may suffer and potentially exacerbate a global slowdown.
Pricing in share and bond markets reflects the aggregate decisions of all investors as they weigh up their views on the outlook. While global growth is modest and slowing, interest rates are supportive. The US China trade war remains on close watch by investors as this presents a clear risk that could quickly derail global growth.