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Question: Are We Heading Into A Recession?

Stuart Lucy

Stuart Lucy is an Investment Specialist at the Australian Stock Report, and has gained exposure to funds management and investment banking throughout his career. He draws on this experience to provide macroeconomic commentary and actionable investment insights to clients. Stuart is responsible for writing reports, is involved in delivering Macrovue webinars and provides general advice to our members on portfolio construction. Stuart currently holds RG146 General and Securities qualifications.

The ASX declined 3.2% over the past 5 days, led by a weak showing from Wall St. The selloff is global in nature and was mainly led by weak PMI data from the US and Europe. The US ISM manufacturing PMI index came in at 47.8, well below the 50 level that demarcates expansion from contraction. This reading was the worst on record since the GFC and highlights growing cracks in one of the few drivers of global economic growth. With markets approaching all-time highs, this catalyst was adequate to cause a sell-off in stocks. Trump capitalised on the data to argue for more Fed rate cuts, arguing that their decision to keep interest rates at current levels is holding the dollar high and limiting the ability of the United States to compete in the trade war.

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While the current bull market has been very profitable for investors, it is still worth assessing recession risk (Credit: Guardian)

Asian markets also declined, following North Korea’s decision to fire a ballistic missile that is believed to have come from a submarine, as part of a test. The country is in working-level talks with the United States, but the decision signals a potential escalation of tensions in the region.

Another reason for Aussie markets being dragged down is poor new car sales data, indicating weakness in the Australian economy specifically. Since automotive sales are a good indication of broader economic activity, it indicates that the RBA’s interest rate cuts are not feeding through to the underlying economy as quickly as some commentators hoped. While monetary policy typically has a 12-18-month time lag before it effects fully flow through to the rest of the economy, it is likely that the current stimulus is flowing mainly to the housing market. House prices are up substantially across Australia, but the underlying economic data, particularly in unemployment, looks fairly lacklustre, which indicates that most people would prefer to invest than spend.

How Is Healthy the Global Economy at the moment?

 

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Credit Suisse Recession Scorecard (Source: Credit Suisse)

 

Economic Growth: The main factor concerning economists is a slowdown in US growth, which is facing increased pressures from the trade war and a slight headwind from the facing impact of corporate tax cuts two years ago. The spread of the slowdown to services is concerning, but the sector is still in expansion.

The EU is very close to contraction, with a broad-based PMI coming in at 50.1. Germany is almost certainly in a moderate recession, while the UK’s economic data is pointing to downgrades that may culminate in a recession. While this sounds exceedingly negative at first glance, it is important to remember that the Eurozone has not been a driver of global growth for a long time, and the US and China both have healthy growth rates, albeit ones that are slowing down.

Corporate profit margins: Companies are more profitable when times are good, and their margins generally peak around 30 months before a financial crisis. Since this is very unlikely to have already happened, the global economy is unlikely to go into recession over the next couple of years.

Debt servicing costs: One factor which can predict the susceptibility of an economy towards a recession is the cost of meeting interest payments on debt. If companies are paying 50% of their profits in interest, they are generally more likely to default on their debt than if they were paying 10%. While the absolute levels of debt have increased, a shift to a lower interest rate environment has enabled companies to cope with their interest bills much smaller, making the global economy more stable.

Inflation: A pickup in inflation typically precedes a recession, since it is a tell-tale sign that the economy is overheating. A cycle will typically start by which high consumer confidence results in more demand for goods and services, allowing companies to charge higher prices (causing consumer price inflation). Workers will then ask for higher wages to account for an increase in living costs. This results in a wage-price spiral that ultimately culminates in a recession, as central banks increase interest rates too rapidly.

Inflation around the world is very subdued at present, which allows central banks to continually cut rates without the concern of price pressures. This indicates that the economy is not overheating, and growth is broadly sustainable. The backdrop of central bank policy easing means that, if a recession does eventuate, it will look very different from most of the recessions before it.

Employment: The US labour market is very strong, with unemployment coming in at the lowest level since 1969. An emphasis on reducing long term unemployment, backed by public and private sector initiatives, have reduced the natural rate of unemployment and made it possible for the economy to keep accelerating. While unemployment is higher domestically and there is still some spare capacity in the labour force, the labour market is still in a healthy position. A deterioration in the labour market will typically precede a recession, so employment data suggests that a recession is not likely in the near future.

 

How does This Impact Stocks?

When investing in equities, it is particularly important to have a view on the economic outlook, as stock prices are heavily dependent on investor sentiment towards the economy. This is because the asset class involves getting exposure to the most volatile component of a company’s capital structure, with less volatile components being corporate bonds and debentures.

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Corporate Earnings are taking a slight turn for the worse (Credit: JP Morgan)

 

One place you can invest in during a financial crisis and outperform is gold miners. Gold has been a stable store of wealth for thousands of years and is favoured by multi-asset institutional investors in a downturn. It is also attractive to people who distrust governments and subscribe to conspiracy theories around central banks. While we are not advocating such an outlook, those people will increase in number during economic downturns, since individuals are more likely to question technocratic institutions when the economy is doing poorly than when it is doing well. All these factors combine to make gold an attractive asset class in an economic downturn.

One indicator that is used to see whether the economy will go into recession is the 2s10s spread. When investors worry about the economic cycle, they prefer to buy long term bonds since they go up more than short term bonds. To illustrate why to suppose you held a $1,000 bond paying a $50 a year in interest for the next 10 years. Imagine interest rates suddenly fell by 5%, and new bonds that sold for $1000 now paid a 0% interest rate. Investors will clearly pay a lot more for the first one since it makes more money, pushing the price of the initial bond up. This effect is more muted over shorter time horizons.

This is why investors like longer-term bonds as much as shorter-term ones when they think the economy will contract. Bond markets have, in the last four market cycles, predicted contractions far earlier than the stock market. The difficulty is that the stock market generally rallies 13% over a few quarters after the first yield curve inversion. If history is any guide, now is not the time to exit the markets completely, but it is the time to invest more defensively.

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Global GDP growth is slowing, but not as fast as Aussie growth in the last quarter (Credit: RBA)

 

Even if a recession looks likely at some point within the next few years, most investors will continue to hold cyclical assets like shares for their long-term growth potential. Nevertheless, it is important to monitor the state of the economy and adjust the portfolio to a position somewhat defensively when the outlook deteriorates, while still leaving some room to profit if the economic outlook improves. This is why gold miners are attractive assets – they offer the same long-term growth potential as other well managed businesses but are countercyclical. As such, investing in gold miners is not just a way to bet on an economic downturn, since the position can also be used to hedge existing investments in other assets.

 

Is the ASX Well Positioned for a Downturn?

While the ASX has a lot of attractive defensives, the index as a whole is heavily weighted towards cyclical industries, with half the index in financials and mining. Since we have not had a recession in three decades, many investors seem to have forgotten how cyclical financials are. This can easily be seen in continued media assertions that banks are “safe” investments, which clearly ignores waves of bank collapses every decade or two in major economies around the world.

One possible source of a downturn in the US-China trade war, which the ASX is particularly exposed to since China is by far our largest trading partner. Companies in Australia can be directly exposed to the Chinese growth story through either the daigou channel or direct business relationships. The daigou channel has been hit in recent times, with China now requiring people operating daigou businesses to acquire licences to operate daigou businesses in both China and the other country they operate in, meaning those companies are subject to the same taxation as normal businesses. This has hurt Australian businesses reliant on the daigou channel, since it increases the average effective rate of tax consumers in China pay on their goods, pricing some consumers out of the market.

This has resulted in particularly bad effects for milk companies such as A2 Milk (ASX: A2M), Bellamy’s (ASX: BAL), Bubs Australia (ASX: BUB) and Blackmores (ASX: BKL). A2 Milk sold off earlier this year, as China ratcheted up regulations on the importation and advertising of foreign infant formula. A2 can no longer advertise infant formula in the 0-12-month-old market segment, and China is set to favour domestic producers which it wants to obtain a 60% market share.

Blackmores has also been hit heavily after announcing a disappointing quarter of Chinese sales. Their sales in Asia excluding China rose by 30%, along with flat sales across Australia and NZ. China was the only weak spot in their recent results, with the increased regulation of the daigou channel driving a 15% decline in Chinese sales. This brought overall sales growth down to 1%, along with a profit decline. The result capped a ~70% decline from the company’s share price at its peak, highlighting the risks of over-reliance on the Chinese market at the present time.

If the trade war expands to other countries and products or leads to an economic slowdown, the big miners like BHP Billiton (ASX: BHP)Rio Tinto (ASX: RIO) and Fortescue Metals (ASX: FMG) could come under pressure.  Treasury Wine Estates (ASX: TWE) is also heavily exposed to Chinese imports and will also lose out from broader protectionism and tariff rises. While these stocks are not reliant on the daigou channel, which is coming under increasing pressure, they have direct sales contracts with Chinese companies. These could put pressure on share prices, should the Chinese government puts tariffs on countries other than the US in an escalation of the trade war.

Domestically focussed Chinese businesses, however, have less trade war related risks, because their products will not be subject to tariffs in the Chinese market. This makes investing in companies that are based in China or Hong Kong a great way to play the Chinese growth story, whilst minimising exposure to trade war related risks. With 98% of listed investment opportunities offshore, it makes sense to invest internationally.

 

Macrovue

Typical issues which Aussie investors have with investing offshore include more limited knowledge of companies outside, sky-high brokerage costs at the major brokers and not knowing where to start. We side-step these issues through developing a platform called Macrovue, where a top performing fund manager identifies attractive international investment opportunities for us to look at. We pay $15 a trade for brokerage and have a clear direction on which economic trends we are investing in. As one of the only platforms offerings managed portfolios without performance fees, it’s worth looking at a couple of the themes we are looking at. The portfolios each have several stocks that investors can pick and choose if they wish:

Warren Buffett Top 10 (11.21% LTM): While the Oracle of Omaha needs no introduction, the $400k price tag of one of his class A shares prices many investors out of the company. To address this issue, we created a portfolio tracking his top 10 holdings, allowing you to instant access to the wisdom powering the 20% average returns for 60 years that Buffett delivered to his investors.

Luxury goods (+4.82% LTM): Luxury goods producers have high-profit margins and sticky customer bases, making them excellent long-term investments. They are particularly well-positioned to take advantage of the growth in China, given the high levels of luxury goods expenditure amongst the nation’s booming middle and upper class. Many of the companies in this view have significant family ownership stakes, including Hermes and LVMH, protecting them from short term biases in decision making.

5G Wireless Technology (32.65% LTM): 5G technology is the driving force enabling most of the game-changing technologies over the next decade, from autonomous cars to smart homes. With most of the US and Europe poised to roll out 5G technology over the next few years, companies exposed to this trend are expected to see massive revenue growth.

 


 

Disclaimer:

This article has been prepared by the Australian Stock Report Pty Ltd (AFSL: 301 682. ABN: 94 106 863 978)

(“ASR”). ASR is part of Amalgamated Australian Investment Group Limited (AAIG) (ABN: 81 140 208 288 Level 13, 130 Pitt Street, Sydney NSW 2000).

This article is provided for informational purpose only and does not purport to contain all matters relevant to any particular investment or financial instrument. Any market commentary in this communication is not intended to constitute “research” as defined by applicable regulations. Whilst information published on or accessed via this website is believed to be reliable, as far as permitted by law we make no representations as to its ongoing availability, accuracy or completeness. Any quotes or prices used herein are current at the time of preparation. This document and its contents are proprietary information and products of our firm and may not be reproduced or otherwise disseminated in whole or in part without our written consent unless required to by judicial or administrative proceeding. The ultimate decision to proceed with any transaction rests solely with you. We are not acting as your advisor in relation to any information contained herein. Any projections are estimates only and may not be realised in the future.

ASR has no position in any of the stocks mentioned.

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