Macro forecast 2018: Part 1

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<p><strong>Glenn Freeman</strong>: I'm Glenn Freeman from Morningstar and I'm here to talk to Peter Warnes to get the highlights of his 2018/19 forecast report.</p> <p>Peter, thanks for your time today.</p> <p><strong>Peter Warnes</strong>: Always good to be here, Glenn.</p> <p><strong>Freeman</strong>: Let me just kick it off we're talking about the &ndash; you've got some pretty interesting comments about the economic cycle and you're saying how we're not &ndash; it's not normal, the way that things have unfolded since GFC and where we are now with regard to fiscal policy, monetary policy, what's happening here?</p> <p><strong>Warnes</strong>: Glenn, what I have been saying for quite a while now since September last year that one of the clouds on the horizon for the financial markets globally has been the potential clash and clash on a major, major scale of fiscal and monetary policy in the US. This has come about because the Fed has been purchasing assets since the GFC has a balance sheet now of over $4 trillion and it has to be normalised, interest rates have to be normalized and fiscal policy should be going hand in glove with that.</p> <p>Now, in the normal economic cycle, you have fiscal and monetary policy working together. So, the normal cycle is you have a start off with a low interest rates and that encourages activity and as those low interest rates and the government on a fiscal side, running deficits they were supporting low interest rates with increased government expenditure than you get demand driving the economy and ultimately you get if you're like a boom.</p> <p>Now, as you get close to that boom, what happens is that capacity utilization is under pressure, prices go up, inflation starts to emerge and then the central bank has to say, hang on a second, this is going too fast too quickly, we will start quietening it down. So, what do they? Do they put interest rates up and at that time, that the monetary policy, the government, starts running surpluses, in other words, withdrawing or lowering government expenditure. And so, that quietens the economy down and then you have the peaking and then down we go again to the trough and then up we go again.</p> <p>So, the expansion and contraction over an extended period, but over a decade &ndash; we have the decade cycle. We haven't had that now since the GFC. So, GFC 2008 &ndash; we're 2018, we haven't had any interruption in a normal sense of the two policies working.</p> <p>So now, in the US in particular, we have the Fed which started increasing interest rates in December 2015, they have increased rates seven times. They are starting to normalise their balance sheet, selling assets they had repurchased to get the economy moving post GFC. And that should push interest rates up because the economy is starting to move, the inflation starting to look a little bit more elevated and they want to normalize again monetary policy and their balance sheet.</p> <p>In comes Donald Trump and says tax cuts and funded a $1 trillion worth of infrastructure spending. So, the US treasury has to go out in the market and fund that by issuing bonds. So, that means that he is clashing. It's a clash between monetary and fiscal policy.</p> <p><strong>Freeman</strong>: Has this happened in the past, this sort of clash?</p> <p><strong>Warnes</strong>: Well, it may have happened, but not to the extent its happened because again the problems that GFC presented to us, we've never seen that either. So, you've got a major clash there. Now normally &ndash; in a normal situation, that wouldn't happen, but now you've got it. So, interest rates have to go up and Feds push them up, but the bond market which is many many times bigger than the equity markets is saying, Well, hang on a second. We're standing off here. We are not accepting what's happening. Because bond yields move when inflation runs or is on the run and the economic growth which supports inflation if you like will drive some inflation is on the run as well. Now, when the Fed moved first in December 2015, the 30-year bond was 3%. It's 2.95% today after seven increases in official rates in the U.S.</p> <p><strong>Freeman</strong>: Still at that level.</p> <p><strong>Warnes</strong>: The 2 year 30-year spread over 2 year 10-year spread is down from 70 basis points in February to 28 today. So, the bond markets are saying &ndash; the bond market is saying, we don't believe inflation is a problem or we don't believe that the economic growth is sustainable. So, even in that whole scenario, you've had a &ndash; the Central Bank has put this &ndash; blown up a balloon if you like, and it's inflated &ndash; just about at bursting point, they've got to start taking the air out, in other words, all liquidity that's gone into that balloon, that's a dangerous exercise at the best of times. But now you've got this other situation where fiscal policies is against it. The chances of something coming unstuck there are relatively high and then if that happens, then interest rates and bond yields are going to go north very, very quickly.</p> <p><strong>Freeman</strong>: Could this also flow onto other markets, say is Europe potentially exposed to something similar happening or have they got some quite fundamental differences?</p> <p><strong>Warnes</strong>: Well, they haven't got the same problem as the U.S., because they haven't got someone sitting there with you know &ndash; throwing money and stimulating the economy. They've got the same problem; the ECB has the same problem as the Fed has got. They almost going to &ndash; they'll seize asset buying at the end of this year and then they will start you know rationalizing or normalizing their balance sheet. But they are way behind what the Fed's doing. And so, no, it will be &ndash; the Fed will &ndash; is leading and the problems in terms of bond yields will happen in the U.S.</p> <p>Yes, other markets will follow, but the U.S. will be a leader there. And of course, don't forget those bond yields, the 10-year one in particular, that is your benchmark risk free rate of return which &ndash; of which discount rate are used to value equities and capitalisation rates are used to value property. So, the risk assets which basically are interest rate driven if you like, are going to be under pressure.</p>

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