If you’d asked about the market this time last year, the consensus would have been “bullish”. For the first time in a long time, sentiment seems to be split between bulls and bears and price action is showing it. Notwithstanding your view of when and where the top may be taken out, this is a good time to consider trend.
As a student of international macroeconomics, I can tell you that a recession in the US will have a knock-on effect here in Australia. No matter how hard you argue that China is a more important trading partner than the US or Europe, you have to concede that China is beholden to the US and that therefore what happens stateside affects what goes on here. With a US recession, a chain of events will ensue: the slowdown in the US will lead to a decrease in Chinese exports, which will lead to a falloff in Chinese imports, which will lead to a tightening of Australian exports. It will come home to roost.
A recent paper by the Reserve Bank of Australia suggests that there is about 84% correlation between Australian GDP and US GDP and a two-month lag before economic factors in the US are felt here. In last week’s edition of Trading Tutors, Tom Scollon underscored the effect US interest rates have on economic matters here. I’d like to expand on this to illustrate what our share market needs from the US Fed. If the Fed does not deliver a further rate cut, the US economy could go into recession and we would feel the pinch.
Chart 1 – CT-SpotV Daily Bar Chart
click chart for more detail
The yield curve for the US bond market shows two distinct ‘flavours’. You have a normal upward yield curve that awards investors according to how long their cash is invested. Then you have the interesting part: the discontinuity around the two-, three- and five-year area of the curve, where the yield ‘bulges’ lower. This is a signal that interest rates should fall in the medium term. What causes them to fall? You guessed it, lower GDP growth and (heaven forbid) a recession. This is only the medium term outlook, however, and the share markets should price this in as they focus further on forward growth rates. Nothing concrete here, but it does suggest that the US could be struggling.
What should we look for? If longer term rates begin to fall and the yield curve flattens further, a recession becomes more likely. If longer term rates fall beyond short term rates and the yield curve inverts it’s a sign that growth is not sustainable and recession will rear its ugly head.