Recent weeks have seen global sentiment cool off as US-China trade talks turn positive. Granted, the inverted yield curve that gave a warning sign in the summer has already turned and while the mood is lightening, there are still some dark signs that point to a recession just around the corner.
The Equity Market
The equity market has sustained record high levels in an environment of flat revenues. The current corporate profit cycle started in 2016, and a retracement was expected after companies posted flat earnings in the first three quarters of 2019. But high valuations have persisted in the market, due to positive trade talks, and a change in the monetary policy environment. The US has cut rates thrice in 2019, but during the October meeting, the Federal Reserve signalled a pause in further rate cuts. The worry is that the current monetary policy has supported the high equity levels, rather than actual company fundamentals. A less favourable, even constant monetary situation would trigger the chase for fair valuations and will likely pressure stocks lower.
Still, the biggest cause for concern is sovereign debt. The US already crossed the psychological $20 trillion debt barrier and is well on course to top $1.3 trillion in 2019. The last time the Fed ran $1 trillion in annual deficits was during 2009-2012 when an aggressive quantitative easing program was implemented following the 2008 global financial crisis. The Fed has already stated it is not undertaking any quantitative easing program at the moment, and the US economic data does not make the case for one. The economy is close to full employment and there have been a stream of overall positive economic data. In such an environment, the wisdom is always to cut federal deficits and hike rates. The fear is that there will likely be no bullets left for the Fed to utilise when things go south from here. This potentially means that any decline can easily turn catastrophic or unmanageable.
The US is delivering some warning signs in a seemingly bright environment, but the situation is gloomy in the Eurozone. The common region has posted a mild and shaky recovery in 2019, but one of the major economies in the bloc has emerged as a huge risk factor. Italy avoided a political nightmare in September when a snap election was averted following the resignation of the country’s Prime Minister and the collapse of government. But the country’s even bigger problem is its public debt; which at $2.3 trillion, represents more than 133% of its GDP. During the global financial crisis, the Greece debt crisis weighed down on the entire Eurozone region. Italy, though, delivers an even bigger scare. Its economy (the third largest in the Eurozone) is ten times that of Greece, and any domestic crisis will have an even bigger doom loop effect on the entire region.
There is also another important indicator that investors must pay more attention to; the Consumer Sentiment. One of the major indicators for tracking this is the University of Michigan’s Consumer Sentiment Index, which has been turning lower for the better part of the year. As well, it has been suggested that in the current interconnected world, we can literally talk ourselves into a recession. The idea of narrative economics or viral recession can lead to consumers shifting their behaviours accordingly. They can save more or even cut their spending, and their collective negative sentiment is a major threat to corporate profits. There has been a stream of negative news throughout 2019 and there are major political events, such as the UK Brexit and the US general elections in the coming year. If consumer behaviour continues to be more risk averse, then the recession can easily become a self-fulfilling prophecy.
When turbulence is around the corner, investors worry even more about their money. The tendency is to look for opportunities in the fixed-income market, such as bonds and government treasuries. Safe haven commodities, such as gold and nowadays, even cryptocurrencies, may appeal to investors willing to chase risk in a depressed market. But there may be even bigger opportunities in the stock market where short selling strategies can yield bigger returns as investors express their collective fear.