The Global Fiscal Panic

International | Jul 09 2019

As global recession looms, analysts warn of a fiscal panic that will grip the world as monetary policy easing reaches its limits. Australia is not immune this time.

-End of globalisation
-Massive fiscal response ahead
-Inflation to return
-Australia's dream run at risk

By Greg Peel

Society has reached an inflection point on several fronts, suggests Saxo Bank in its third quarter outlook, which will have profound implications for global equities. We have reached the end of globalisation as we have known it since the 1980s.

Saxo believes globalisation has reached a maximum, even before considering the US trade war with various countries that implies a big step away from globalisation in terms of free trade. Chinese manufacturing has now reached a level at which exports will cease to become any cheaper. A "massive" focus on the environmental impacts of all forms of consumption, from plastics to packaging to airline and sea transport pollution, will push up the unit cost of production.

Add in the trade war, a fiscal stimulus push into infrastructure and the shoring up of damaged global supply chains and central banks wrongly, Saxo suggests, focused on excessively low inflation, and the result is a "perfect storm" brewing that will turn back the tide of inflationary outcomes.

All of the above leads to a "massive" repeat of the 1970s global supply shock, the analysts warn.

The shock will come sometime after global fiscal expansion is unleashed in the third and fourth quarters of 2019. To this point we note many an economist has suggested QE simply hasn't worked. They cite one example as Europe's failure to drive a return to economic growth in the decade since the GFC despite doing "whatever it takes" monetarily, to quote outgoing ECB president Mario Draghi, held back by enforced post-GFC fiscal austerity.

The failure of monetary policy will lead Europe, and the rest of the global economy, into recognising the need to reverse austerity and dive into fiscal stimulus, Saxo implies. A spending spree can comfortably be funded at historically low interest rates. Such a policy comes under the banner of Modern Monetary Theory.

Australians have recently witnessed the RBA governor's plea to the federal government to provide fiscal spending support to increasingly less effective monetary policy easing. More and more commentators are despairing at the government's mindless obsession with returning the budget to surplus at a time the Australian economy is slowing and borrowing rates have never been so low.

By mid-2020, we will have seen the end of any belief in global monetary policy moving the needle, suggests Saxo, and will be witnessing "extravagant" spending driving inflation to levels beyond expectation, just a couple of quarters after inflation has been "pronounced dead".

The chance of a recession is probably much higher than global equity markets are currently reflecting, in the analysts' opinion, with yield curves and leading economic indicators sending the strongest warning signal to investors. The OECD's global economic indicator marked its 17th straight month of decline in April. History has often showed there is a final bullish move in equities despite clear evidence of an incoming recession.

That is exactly what we are witnessing today, says Saxo.

"The US Federal Reserve is playing catch-up, and, if we see material signs of weakening in the third quarter, the Fed will axe rates to the effective zero bound instantly and could even restart quantitative easing before year-end."

With US bond yields pricing in the risk of a US slowdown, and the impact of Trump's tax cuts rolling off, clearer signs of a weaker US economy should soon emerge. Saxo expects a weaker US dollar in the second half of 2019 as the Fed delivers strong easing.

This would give gold and commodities in general the tailwind they have been missing in recent years, as would a global fiscal panic leading to governments spending money they don't have. Inflation would come "roaring back".

The biggest risk to Saxo's scenario of rising commodity prices is, conversely, the potential for the US and China to actually reach a trade deal, which would likely reduce expectations of how far the Fed would need to cut.

The Wonder Downunder

Australia's near 30-year recession free run, the envy of central bankers around the globe, is now at risk, Saxo market strategist Eleanor Creagh believes. The "wonder downunder" that escaped zero interest rate policy, negative rate policy and QE will not be so lucky this time around. Monetary policy is ineffective for the challenges Australia faces.

"Monetary policy will never replace sound economic policy. So, rather than relying on central bankers to clean up the mess, the government must deliver productivity-enhancing reforms, infrastructure spending and other fiscal measures to restore confidence and start a self-sustaining recovery in economic growth."

While the RBA hopes it will not need to resort to unorthodox measures, Creagh suggests QE is not beyond the realms.

US firm T. Rowe Price believes investors need to be cautious in the near term as external risks are rising. Head of Australian Equities, Randal Jenneke, notes the Australian equity market has performed strongly in 2019 but investors have been more rewarded by lower bond yields, the unrealised risks of a Labor government or any slowdown in China's housing market than any real shift in fundamentals.

Jenneke sees this as a temporary reaction, and expects a return of focus to more fundamental factors such as ongoing US-China trade tensions and domestic housing weakness.

Concerns of a trade policy-induced global slowdown will continue to dominate markets in the short term, with potential longer term implications if other countries look to shore up greater self-sufficiency. The real danger is that of global trade grinding to a halt, which, says Jenneke, would have very serious consequences for Australia and global markets.

Companies are already responding by reducing inventories and capital expenditure plans, which leads to lower GDP and employment growth at a very inopportune time, given the global economy is much less robust than a year ago.

While T.Rowe believes the RBA and APRA have now removed tail risk from the housing market, it does not mean the housing market is set to take off again. Rather, Jenneke expects stabilisation in the second half of 2019 and some limited improvement in domestic growth.

T. Rowe's team sees markets behaving in "fits and spurts" for the rest of the year, such as was the case in December last year, which will provide the longer term investor with an opportunity to buy high quality defensive names.

Jenneke remains most optimistic about healthcare, where there is less threat of competition, more market share consolidation and more durable and stable business models. He also believes good opportunities remain in stocks exposed to the Chinese consumer, select multinational growth companies with big offshore operations, along with industrials and consumer staples.

T. Rowe leans towards companies with strong balance sheets, excellent profitability and strong earnings growth.

On the flipside, T. Rowe is reducing holdings of high-beta, economy-sensitive companies.

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