When times were really bad

The decade since the GFC has been bad but it’s not without precedent

Some of us (almost) superannuated market scribblers have for some time been fearful of what looks like the current inflection point in markets. This probably reflects our recollection of a time when things were different and, in my view, a whole lot worse – the 1970s. As if to prove the rock ’n’ roll maxim that “anyone who remembers the 1970s didn’t properly live them”, a lot has been written about how “unprecedentedly” bad the decade since the GFC has been economically. But by my reckoning it wasn’t as bad as the ’70s and, for that matter, the first couple of years of the ’80s.

Those times were a real doozy: doubledigit unemployment, double-digit inflation and double-digit interest rates, and if that weren’t enough to make the average punter miserable he or she could have been invested in a stockmarket that went nowhere – the S&P 500 fell by around 40% in real terms over the decade of the ’70s.

Warning signs

There are those among us who are fearful that recent times may be a harbinger of things to come. This is because the pre-conditions for higher bond yields remain.

First, the US economy is at full capacity. The unemployment rate is as low as it has been since 1969. Moreover, it has strong and ongoing growth momentum that may well poke the inflation beast.

Second, the Fed has more “shots in the locker”. Fed chairman Jerome Powell told us that we’re “a long way” from neutral. From its current level of circa 2.25%, the Fed “dots” anticipate a Fed funds rate a little above 3% by the end of 2019.

Third, the Fed is forecast to reduce its balance sheet (holdings of treasuries and mortgage-backed securities) from around $US4 trillion to $US2 trillion by February 2021. In other words, one of the biggest buyers of bonds in recent years is absent from the market.

Fourth, despite being at full capacity, the US is forecast to run a budget deficit of close to 5% of GDP in 2019. In my view, this goes stunningly unremarked upon in broader market commentary. Not only does the US fiscal position add to inflation but to fund the deficit the US Treasury has to issue more bonds.

Incidentally, and a little ironically given the protectionist crusade conducted by the US administration, the excess demand created by that fiscal stimulus will inevitably spill over into more imports. Perhaps the president should look in his own backyard before accusing the Fed of having gone “crazy”.

Domestic headwinds

That is all bad enough but I haven’t even touched on the domestic implications. There are emergent headwinds to meeting the Reserve Bank’s relatively optimistic growth forecast of a little over 3%. In large measure this reflects an uncomfortable confluence of the imbalances wrought by excessive household debt (mostly mortgage debt) and a deteriorating Chinese growth outlook, which itself is a combination of domestic imbalances and fallout from the trade dispute with the US.

I think that this means the RBA won’t be lifting rates until at least 2020 because inflation won’t get sufficiently inside its target range.

In terms of the consequences for markets, the most obvious one is further and potentially sharper falls in the $A as the interest differential with the US rises, with the RBA on hold and the Fed pushing on with rate rises.

This may be an important safety valve that ultimately cushions any diminution in growth – but it is only a cushion and only occurs after a lag.

The other consequence is that house prices may continue to decline. Continuing curbs on private lending (regulatorily induced or self-imposed by the banks in the wake of the royal commission) may intensify deflation in house prices, reducing household wealth and thus household consumption and sending GDP growth lower.

So the recent turmoil on global markets does have real consequences for us here. As bad as the ’70s? Probably not, but depressing nonetheless. And if that is not enough, I can dust off my ’70s Joy Division vinyl!