Investment markets and key developments over the past week
After a strong start to the year global shares came under pressure over the last week as bond yields rose further, in part driven by rising expectations for more aggressive Fed monetary tightening and rising US wages. US shares fell 3.9% for the week, eurozone shares fell 3.1%, Japanese shares fell 1.5% and Chinese shares lost 2.5%. However Australian shares managed to rise 1.2%, having significantly underperformed since the start of the year and missing out on Friday’s fall on Wall Street. Bond yields continued to back up sharply in the US and Europe but were flat in Japan and Australia. Commodity prices mostly fell and a rebound in the US$ on Friday saw the A$ fall 2.2% for the week, taking it back below US$0.80.
Correction time for shares. After a strong start to the year and very low volatility last year, US and global shares had become overbought and overdue a decent correction, and this now seems to be unfolding. From their recent high, US shares have fallen 3.9%, making it their sharpest pullback since a 4.8% fall prior to the November 2016 US election. The correction likely has further to go as the market adjusts to more US Federal Reserve (Fed) tightening than currently assumed and higher bond yields. Furthermore, this will impact most major share markets, including the Australian share market which is vulnerable, given its high exposure to yield plays like REITs and utilities. However providing the rise in bond yields is not too abrupt, the correction should be limited, and shares will likely still see reasonable gains this year thanks to rising earnings. Historically, rising US wage growth is positive for profits as it drives stronger spending – until of course it turns into an inflation problem prompting tight monetary policy, but we are still a long way from that.
In the US, the Fed left interest rates on hold at its first meeting for the year, but was more upbeat on the economy and inflation signalling more rate hikes ahead, with the next move almost certain to be in March. With the US economy so strong and inflation risks shifting to the upside as evident in a pick-up in wages growth to 2.9% year-on-year on January, we see the Fed raising rates four (or possibly even five) times this year, which is still more than the three the market is now allowing for. Reflecting this, we see more upside for bond yields ahead.
Meanwhile, other central banks remain a long way from a hawkish shift. Bank of Japan communications and a lift in its shorter-dated bond purchases look aimed at convincing markets it’s not about to raise its zero 10 year bond target. The European Central Bank (ECB) looks like remaining patient (despite some ECB officials), with core inflation of just 1% in January. In addition, softer than expected December quarter inflation in Australia is consistent with the Reserve Bank of Australia (RBA) remaining on hold out to later this year. A more hawkish Fed, at a time when other central banks remain dovish, should ultimately support the US dollar.
President Trump becoming more conciliatory. A worry for this mid-term election year in the US is that President Trump will become more populist to appeal to his base. His decision to impose tariffs on imports of washing machines and solar panels was a move in this direction but his recent speech in Davos and his State of the Union address actually moved in the other direction, with a more conciliatory presidential tone, no big threats on trade and positive statements about progress on NAFTA. And it’s worth noting that the tax cuts and news of companies making cash payments to workers as a result is helping to boost popular support for the GOP.
As goes January, so goes the year – or does it? The so-called January barometer that takes January as a guide to how the year will go has long been looked at around this time of year. With global shares up 3.8% and US shares up 5.6% in January it’s positive for this year, but for Australian shares its negative with shares down 0.5% in January. However, the January barometer tends to be far more reliable for positive Januarys than negative Januarys. Since 1980 a positive January in the US has had an 86% hit rate of going on to a positive year, but a negative January has had only a 40% hit rate of going on to a negative year. In Australia, a negative January has had just a 29% hit rate of going on to a negative year, so I wouldn’t read too much into January’s fall as a guide to the year as a whole for Australian shares. Of course, even for positive Januarys it’s not full-proof and in 1987 US shares saw a whopping 13% gain in January - they still had a positive year in 1987 but it was only 2%!
So why did Australian shares underperform so badly in January? Basically, the further rise in the Australian dollar weighed on earnings expectations, the rise in bond yields weighed on interest rate-sensitive parts of the market like REITs and utilities - to which the Australian share market remains more highly exposed - and earnings expectations at around 7% in Australia remain well below the rest of the world, where earnings growth is running around 10-15%.
Major global economic events and implications
US economic data remains solid with consumer confidence and the ISM manufacturing conditions index remaining very high in January, continuing strength in personal spending, a solid rise in construction spending, strong labour market data, an acceleration in wages growth and a pick-up in inflation. January jobs data showed a stronger than expected rise in payrolls of 200,000, unemployment remaining low at 4.1% and most importantly a further acceleration in wages growth to 2.9% year-on-year, its highest since 2009. Quite clearly the tight US labour market is feeding through to faster wages growth. Consistent with the strong US economy, the December quarter US earnings reporting season has continued to impress. Of the 251 S&P500 companies to have reported so far, 80% have beaten earnings expectations and 79% have beaten on sales. Earnings growth for the quarter is tracking up 14.5% year- on-year and revenue is up 8% year- on-year, which is its strongest in six years.
Eurozone economic data also remains strong with GDP growth of 2.7% through 2017 (up from 1.9% in 2016) and continuing high readings for business and consumer sentiment. Core inflation in January edged up, but only to 1% year- on-year.
Japanese data was a bit mixed with a soft reading for household spending but continuing strength in industrial production, business conditions and the labour market.
Chinese business conditions PMIs were on average little changed in January, suggesting that growth remains solid.
Australian economic events and implications
It was a bit of a mixed bag in Australia over the last week. Business conditions and confidence remain strong, according to the NAB survey and the AIG and CBA PMIs and the terms of trade rose slightly in the December quarter, providing support for national income. Against this though, building approvals fell sharply, led by volatile units which re-established a downtrend in overall approvals, private sector credit growth continues to slow, home prices fell further in January - led by Sydney - and inflation came in slightly weaker than expected and below target for the December quarter. This is all consistent with the RBA remaining on hold - with no rate rise likely until later this year.
Government related prices helping drive falling real wages. Much has been made of record low wages growth and falling real living standards. However it’s interesting to note that while wages growth has fallen to a record low, price rises for most Australian businesses only averaged 1.1% last year (according to the ABS’s Market sector goods and services, ex volatile items price index). If price rises for government-influenced areas like health, education, utilities and tobacco were similar there would be far less angst about low wages growth!
While it’s dangerous to read too much into December and January property price data given low sales volumes, property prices are likely to soften further in Sydney and Melbourne as APRA tightening measures and rising unit supply continue to impact. Auction clearance rates in Sydney running in the 50’s are consistent with prices falling on an annual basis.
What to watch over the next week?
In the US, it will be back to focussing on shutdown risk with the latest Federal Government funding extension expiring on Thursday.Several issues remain sticking points, including a solution for “Dreamers” so another shutdown is possible. That said, the Democrats are aware of the political risks of pushing this issue too far, particularly as their polling lead is now declining, so any further shutdown is likely to be brief and the economic impact will remain trivial.
On the data front in the US, the January non-manufacturing conditions ISM index (Monday) and job openings (Tuesday) are likely to remain strong, but the trade deficit (also Tuesday) is likely to deteriorate. December quarter earnings results will also continue to flow.
Chinese trade data (Thursday) is expected to show a pick-up in import growth for January to around 8% year-on-year with export growth remaining around 10%. Inflation data for January (Friday) is likely to show consumer price inflation slowing to 1.5% year- on-year and producer price inflation slowing to 4%.
In Australia, the RBA at its first Board meeting for the year on Tuesday is expected to leave interest rates on hold for the 18th month in a row. While we have seen good news on confidence, jobs and retail sales, the combination of continuing weak inflation, near record low wages growth, uncertainty around household debt and consumer spending and the strong Australian dollar mean that it’s way too early for the RBA to raise interest rates. We remain of the view that rates won’t start rising till later this year. A speech by RBA Governor Lowe on Thursday and the RBA’s Statement on Monetary Policy on Friday will provide further insight to its thinking on interest rates. Meanwhile on the data front in Australia, expect a return to a small surplus for the December trade balance (Thursday), a fall in December retail sales (also Thursday) but with strong October and November data resulting in a robust rise in December quarter real retail sales of 1% and a fall in December housing finance (Friday).
The Australian December half 2017 earnings reporting season will ramp up in the week ahead with about 15 major companies reporting including CBA, Rio, AGL and AMP. This reporting season is expected to see a fall back to single digit earnings growth (after the resource driven surge seen in 2016-17) with overall earnings growth around 7% (compared to around 16% in the last financial year), with resources profit growth slowing to around 14% (from 130% in 2016-17) but still supported by solid commodity prices and production growth, bank earnings growing around 3% and industrials up 5% with strong results for insurers, utilities, healthcare, building materials and consumer discretionary. The main themes will be continued strength in companies exposed to housing construction and the infrastructure spending boom, the impact of the US tax cut on companies exposed to the US and the potential for some special dividends and capital returns.
Outlook for markets
For 2018, ongoing strong economic & profit growth and still easy monetary policy should keep investment returns favourable but stirring US inflation, the drip feed of Fed hikes and a possible increase in political risk are likely to constrain returns and boost volatility after the relative calm of 2017.
Apart from the likelihood of a further short-term correction and more volatility through the year, global shares are likely to trend higher through 2018 and we favour Europe (which remains very cheap) and Japan over the US.
Australian shares are likely to do okay but with returns constrained to around 8% with moderate earnings growth. Expect the S&P/ASX200 index to reach 6,300 by end 2018.
Low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds.
Unlisted commercial property and infrastructure are still likely to benefit from the search for yield by investors, but it is waning and listed variants are vulnerable to rising bond yields.
National capital city residential property price gains are expected to slow to around zero as the air comes out of the Sydney and Melbourne property boom and prices fall by around 5%, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms.
Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.
After reaching as high as US$0.8136 which is near the top of the technical channel it’s been in since 2015, the next big move for the A$ against the US$ is more likely to be down than up, as the gap between the Fed Funds rate and the RBA’s cash rate goes negative next month. Solid commodity prices will provide a floor for the A$ though.
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