Continued growth in the US, with some headwinds
The Fed commenced the normalisation of interest rates in December as the US economy continues to perform well in the face of growing headwinds. Unemployment is down to 5 per cent and US households are in a relatively strong position following substantial deleveraging. A strengthening labour market and rising household incomes will provide support to the corporate sector through greater consumption.
Key headwinds facing the US economy include the ongoing strength of the US dollar and further declines in energy prices, which collectively impact trade-exposed industries and those reliant on oil and gas investment. However, most of these headwinds are likely to be transitory, and in the case of energy prices will be offset by material benefits for consumers.
Several transitory factors have been keeping US inflation below the Fed’s 2 per cent target. However, as the oil price bottoms out, the US dollar stabilises, and the labour market recovery continues, wage growth and inflation pressures are likely to normalise. This may force the Fed to increase interest rates faster and commence QT sooner than markets are expecting.
China’s bricks and mortar problem
As the world’s second largest economy, contributing around a quarter of world economic growth, China is key to the global outlook. However, China’s rapid growth has become unsustainable and the economy faces serious short to medium term risks, principally in the property market and the shadow banking system.
Since the global financial crisis (GFC), credit in China has grown by the equivalent of the entire US banking system. Almost half of this credit growth has gone towards property market activity, and a large share of the loans have been made through non-bank or “shadow” lenders. China has now accumulated three to four years of excess housing supply and real estate and related industries account for 20-25 per cent of China’s gross domestic product (GDP). As the property market contracts and the economy deals with an excess credit problem, a recession in China cannot be ruled out. However, the Chinese authorities have a number of policy tools at their disposal and appear to be taking steps to slow credit growth and manage the housing market correction.
Muddling through in Europe
Eurozone growth is likely to remain modest for the foreseeable future. The combined effects of high government debt and unfavourable demographics are likely to present ongoing headwinds for growth, while political impediments are holding back much needed economic reforms. The Eurozone remains vulnerable to major shocks, such as an escalation of the Russia/Ukraine crisis, the election of Eurosceptic parties or a disorderly unwinding of quantitative easing (QE) in the US. Each of these scenarios could trigger a dramatic uplift in periphery Eurozone sovereign bond yields and would heavily test the resolve and mandate of the European Central Bank.
Implications for Australia
Australia’s economy faces a number of global and domestic challenges, with China’s economy slowing, Australia’s biggest mining boom since the 1850s ending, and the Fed entering an interest rate hiking cycle. Mining boom conditions and low interest rates have encouraged households to accumulate large debts, fuelling speculative activity in the housing market which is now likely in excess supply. A contraction in mining and construction sectors could tip the economy into recession over the next few years, while scope for countercyclical monetary and fiscal policy response may be limited. Current macro risks facing Australia emphasise the need for diversified portfolios with exposure to offshore revenue sources across a broad array of sectors.
It is prudent for investors to be cautious in the current macro environment. The normalisation of interest rates by the Fed and the shift to QT could lead to rising risk premia and the repricing of credit and share markets. Meanwhile China’s slowing growth makes linked asset markets vulnerable, particularly those in the commodities and emerging markets spaces. Despite the risks, in our view opportunities remain for investors to achieve attractive returns over the investment cycle, by focusing on high quality businesses with exposure to the growing US economy.