The dreaded ‘R’ word is on the lips of the pundits, with one third of global fund managers surveyed by Bank of America Merrill Lynch predicting a recession in the next year.

Morgan Stanley is tipping a recession within nine months if trade tensions get worse and global interest rates are slumping – a traditional predictor of trouble.

In Australia, economist Peter Brain (National Institute of Economic and Industry Research) says we face the danger of a “risk-off effect” where panicked investors will flee to cash. Stephen Anthony (Industry Super Australia) is saying debt is dynamite: “The question is what lights the fuse.”

To understand all the pessimism, you need to look at some figures. First is the outrageous prices on the US stock market where “equity prices are 70 to 90 per cent overvalued”, Peter Brain said. Here’s a price-earnings graph of the US sharemarket to illustrate his point.

The price-earnings (PE) ratio (the value of a stock as a multiple of its earnings) on the US market stands at 29.6 times, while the average since 1880 is 16.64 times. That means investors are paying way over the odds for shares, and leaves the market open to a crash when they come to their senses.

Worryingly, US PE ratios are equal or higher than levels reached before all major slumps, bar the 2000 tech wreck.

What about Australia?

Here PEs are not so stratospheric, sitting at 16.26 times, while the average is 15. However, this chart produced by the Reserve Bank of Australia shows a worrying trend.

It measures returns from shares compared with no-risk bond yields, and shows that since the end of the GFC, investors have been prepared to take on sharemarket risk more cheaply. The average premium for equity returns over bonds has been 4 per cent, whereas now the figure has shrunk to around 2.5 per cent.

Independent economist Saul Eslake said “investors are taking on more risk for lower returns”.

Mr Brain said that reality is dangerous, and that a US shakeout would translate into “a 10 to 20 per cent fall here”.

Record Lowe – Aussie rates to slide

Bond dealer Charlie Jamieson, of Jamieson Coote Bonds, says the market is expecting RBA governor Philip Lowe to cut the cash rate from the current 1 per cent to a miserly 0.5 per cent – a level it has never been. Already there’s a worrying sign in the bond market.

“Over 20 years, the 10-year bond rate has been an average of 50 basis points above the cash rate. Now the cash rate is 1 per cent, and the 10-year bond yield is 0.95 per cent, so it’s lower,” Mr Jamieson said.

“The bond rate has fallen below the cash rate before, but the difference now is it’s happening when rates are so low,” Mr Jamieson said.

The significance of the rate reversal is that investors are betting that the future will be bleaker than the present, so a wave of money will leave shares and chase bonds.

The big dipper

There are two more worrying signs from the bond market. The US bond rate is so low now that it is below the levels it was before the crash that presaged the Great Depression in 1929, the 1987 Black Monday crash and the GFC – when inflation rates are factored in.

In Australia both the 10-year bond rate and the one-year indices on the Australian Securities Exchange have collapsed by more than 50 per cent in the last year, meaning that fixed-interest investors are very bearish.

It’s different this time

“Investors are behaving in a way that is schizophrenic,” Mr Eslake said. “We have very low bond yields, which means investors are seeking safety, but if that’s the case, why are US equity prices so high?”

The new factor in the equation is the quantitative easing that has seen central banks flood the markets with money as they buy securities from banks to encourage investment. That flood has cut the price of money, disrupting the usual economic signals from the bond market.