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Economy Flirting With Recession as 'Dangerous Potholes' Vex Investors

Economy Flirting With Recession as 'Dangerous Potholes' Vex Investors
(Dollar Photo Club)

By    |   Thursday, 26 October 2017 08:08 AM

In the United States, it’s "Tackling Tax Thursday," with the House of Representatives trying to pass a budget resolution.

There had been a possibility that the Republican leadership would fail to collect enough votes, mainly over concerns about state and local government tax deductions.

Anyway, the vote is still scheduled, and the Republican leadership is sounding at least as confident as they were about healthcare reform.

This is a necessary condition for tax reform to be passed and as such the market risks are asymmetric.

Success of the budget resolution does not mean that much to markets, but failure would be a clear negative for equities.

Over in Europe, at the European Central Bank (ECB) headquarters in Frankfurt, Germany, one could hear on the executive floor something like the sound of muffled banging of a President who is trying to escape from a corner where he is locked in, especially by the Germans, and from where he only will be only allowed out with some type of an agreement to conduct a further form of tightening of his quantitative policy.

The European Central Bank is unlikely to announce a taper as such. Instead, what can be expected is a reduction in its bond buying program for a specified period with a degree of uncertainty about what happens after that.

The ECB is expected to cut its monthly asset purchases from 60 billion euros to 30 billion euros beginning in January 2018 for a period of 9 months, which means until September 2018. It is also expected that the ECB will leave open whether it will extend QE after September 2018. Of course, any ECB decision about its QE program will be data-dependent.

All this will be made in the grand tradition of European decision making by making a compromise between those who wish to see quantitative policy as an unnecessary degree of economic stimulus and those who still consider themselves addicted to easing.

The resulting policy position is likely to be an ECB where the “spin” is accommodative, but the substance is a gradual/slow tightening.

Therefore, the implications for the market and investors of this are, at least for the time being, limited.

Meanwhile, bond markets in Europe, as well as in the United States have started to reconcile themselves to the idea of tightening while currency markets are not nearly beholden to central bank policy as they once were.

Investors could do well keeping in mind that Euro high yield bonds are expensive and therefore can be expected to underperform U.S. high grade bonds as well as a mix of global equities over the next 6 months. Please keep in mind that about one fifth (20 percent) of the European high-yield index offers an effective yield of less than 1 percent with some of the high yield bonds even offering negative yields, which is a situation that is unsustainable under the current circumstances.

For comparison, and here we aren’t even talking about high yield bonds, but when we look at, for example, the U.S. 2-year Treasury that yielded yesterday 1.60 percent and remains set to continue to rise. We know that rising yields translates into falling prices of the related bonds/obligations. This set to happen on both sides of the Atlantic, and that will disturb/upset today’s still way too complacent markets.

The big problem is that all this is set to happen in a world that is over-indebted thanks to the unprecedented low interest rates.

Today’s apparent stability of the U.S. economy faces a serious threat: Consumer-debt levels are now well above those seen before the Great Recession. According to the Federal Reserve, total household debt now stands at $12.84 trillion, which represents about two-thirds of GDP.

Investors could do well keeping in mind the September 2017 IMF report “Household Debt and Financial Stability” wherein we read: “Changes in household debt have a positive contemporaneous relationship to real GDP growth and a negative association with future real GDP growth.”

Now, does all this mean that we are heading for a recession? I still think it’s too early to tell.

One thing is for sure, there are dangerous potholes in the road ahead.

By the way, JPMorgan already calls the next financial upheaval the “Great Liquidity Crisis” that could occur over the next couple of years.

As Miguel de Cervantes said: “To be prepared is half of the victory.”

Etienne "Hans" Parisis is a bank economist who has advised investors on financial markets and international investments.

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Economy Flirting With Recession as ‘Dangerous Potholes’ to Vex Investors
economy, recession, dangerous, potholes, investors
Thursday, 26 October 2017 08:08 AM
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