Investment markets and key developments over the past week
Global share markets were mixed last week with Japanese and Chinese shares up 0.8% and Australian shares up 0.5%, but Eurozone shares flat weighed down by a fall in Italian shares and US shares down 0.5% on the back of rising bond yields and geopolitical worries. Bond yields mostly rose led by strong data out of the US and the spread between Italian and German bonds widened as investors worried about a populist government in Italy. Oil prices rose but gold, copper and iron ore prices fell. A further rise in the US$ weighed on the A$.
US-China trade talks with China’s Vice Premier Liu He have proved “constructive” with China pledging to reduce its trade surplus with the US, buy more US goods and services and toughen intellectual property laws. A trade war has likely been averted. This is very positive. There is a long way to go to work out the details but it’s clear that the US and China have started a constructive process to resolve their differences and have agreed to stop “slapping tariffs” on each other. The risk of a growth debilitating trade war between the US and China has now subsided substantially. The US tariffs on Chinese imports that were due to be finalised by May 21 will almost certainly be put on hold. Both sides can claim victory here – President Trump can claim that his strategy of putting maximum pressure on China regarding trade and intellectual property is working and China will benefit by putting its trade relationship with the US onto a more sustainable footing. This news is positive for global share markets as investors had been fretting ahead of the May 21 deadline. Shares in US companies with significant exposure to exports to China will be key beneficiaries. But it’s also a big positive across Asia and for Australian resources stocks given supply chain linkages to Chinese companies that export to the US. There is a long way to go in terms of specifics, but this development adds to confidence a negotiated solution will be found to the US-China trade dispute and that a trade war will be averted.
Investors finally awaking to the risks around a populist Five Star Movement and Northern League government in Italy. While they are yet to agree a Prime Minister, they are proposing big tax cuts, a basic income, a roll back of pension reforms and a review of EU budget rules. The resultant budget deficit blow out will create tensions with the rest of the EU and put upwards pressure on Italian bond yields with NL leader Matteo Salvini naively bragging that “the spread [between Italian and German bond yields] is going up – do you remember the spread?”. It seems investors do and the spread between Italian & German bond yields rose by 0.37% over the last week and this is now weighing on Italian shares which fell 2.9% over the last week. Market & economic realities may eventually force 5SM and NL to water down their policies in government – which may explain why the leader of neither wants to be prime minister! In some ways this has echoes of the experience of Syriza in Greece that promised extreme populist policies but became just another centrist European political party. An Itexit is not an imminent threat and the risk of contagion to the rest of the Eurozone is far less than it was when Grexit was talked about as other vulnerable countries like Spain are now in much better shape and popular support for the Euro is solid. But a 5SM/NL Government will be bad for Italian assets and poses some risks for the Euro.
At least another spread is falling & that’s the US Libor-OIS rate spread (or the interbank lending rate less the expected Fed Funds rate) and the bank bill rate less expected cash rate spread in Australia has followed. Such spreads have fallen by 0.15% or so over the last few weeks – this is taking pressure off bank funding costs thereby reducing the risk that Australian mortgage rates will rise in compensation. However, a threat to mortgage rates from rising global bond yields is building.
Rising oil prices flowing through to petrol prices and cutting into spending power. Reflecting strong global demand, falling inventory levels and the threat to the supply of Iranian oil, global oil prices have risen around 45% over the last year and this has driven a sharp rise in Australian petrol prices from around $1.25/litre to around $1.45/litre. The lag from higher oil prices to higher petrol prices suggests Australian petrol prices may rise another 3-4 cents/litre in the next week or so.
Naturally the rise in petrol prices feeds directly into inflation, but the indirect impact is likely to be muted in Australia’s case as constrained consumer spending in the face of soft wages growth is making it hard for businesses to pass on cost increases. The weekly petrol bill for a typical Australian household is already up $8 over the last year & up $13 since its 2016 low so it will further constrain consumer spending power.
Major global economic events and implications
US data remains strong. Housing starts fell, but strength in homebuilder conditions points to a continuing rising trend and April retail sales, industrial production, May manufacturing conditions in the New York and Philadelphia regions and the leading index were all strong. The prices received component of the Philadelphia survey is at its highest since 1989 pointing to higher inflation. Our view remains the Fed will hike three more times this year and the money market is gradually coming around to this view…all of which means more upside for US 10-year bond yields. They broke decisively above 3% over the last week for the first time since 2011 and, while negative sentiment towards them suggests the risk of short term decline in yields, they look to be heading to 3.5% by year end.
No early exit from easy money in Japan. The Japanese economy went backwards in the March quarter for the first time since 2015 and core inflation slowed to just 0.4%yoy. While business conditions surveys point to a rebound in growth, falling and way below target inflation confirms that the BoJ won’t be rushing to the exits from easy money any time soon.
Chinese data was a mixed bag in April with stronger growth in industrial production and a fall in unemployment but slower growth in retail sales and investment. Overall it suggests continuing solid growth, but some slowing in domestic demand.
Australian economic events and implications
Slowing jobs growth and still weak wages growth. While April saw a solid gain in employment with full time jobs leading the charge as they have over the last year it was not enough to absorb new entrants to the workforce and so unemployment edged up to 5.6%. Continuing high levels of unemployment and underemployment suggest that wages growth which remained just 2.1% year on year in the March quarter will remain subdued for some time yet. Yeah, I know that wages including bonuses and hours worked look stronger on an annual basis, but both are very noisy and look affected by base effects. Meanwhile, it’s a bit unclear whether the Budget provided a boost to consumer confidence with the ANZ Roy Morgan survey showing a small rise but the Westpac/MI survey showing a small fall. Whatever the impact was it looks pretty small which is understandable given the boost to low and middle-income earners averages out at around $10 a week and won’t be received until after June next year. This is all consistent with the RBA remaining on hold for a lot longer. We don’t see a rate hike until 2020 at the earliest and still can’t rule out a rate cut.
What to watch over the next week?
In the US, the focus will be back on trade and the Fed. Monday is the deadline for finalising the list of Chinese products to be subject to tariffs and it’s also the deadline for the US Treasury to propose restrictions on Chinese investment in the US. Meanwhile the minutes from the last Fed meeting (Wednesday) and a speech by Fed Chair Powell (Friday) are likely to confirm an upbeat view on the US economy and inflation and that it remains on track for more interest rate hikes with the next move in June. They are also likely to push the financial market closer to factoring in another three hikes this year (from expecting just two). On the data front expect May business conditions PMIs (Wednesday) to remain solid at around 55, home sales (due Wednesday and Thursday) to fall back after solid gains in March, home prices (Thursday) to show further gains and durable goods orders (Friday) to rise.
Eurozone business conditions PMIs (Wednesday) for May will be watched for a stabilisation around a still solid 55 after seeing falls from highs earlier this year.
In Australia expect a 0.5% rise in March quarter construction activity (Wednesday) after a very weak December quarter. Skilled vacancy data will also be released and a speech by RBA Governor Lowe (Wednesday) are likely to affirm that the RBA remains comfortably on hold.
Outlook for markets
Volatility in share markets is likely to remain high as US inflation and interest rates move up and as issues around President Trump (trade, Mueller inquiry, etc) continue to impact ahead of the US mid-term elections in November, but the medium-term trend in share markets is likely to remain up as global recession is unlikely and earnings growth remains strong globally and solid in Australia. We continue to expect the S&P/ASX 200 Index to reach 6300 by end 2018, and with the Index now at 6120 it now looks a lot more believable.
Low yields and capital losses from rising bond yields are likely to drive low returns from bonds. Australian bonds are likely to outperform global bonds helped by the relatively dovish RBA.
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 prices are expected to slow further as the air continues to come out of the Sydney and Melbourne property boom and prices fall by another 5% this year, 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%.
The A$ likely has more downside to around US$0.70 as the gap between the RBA’s cash rate and the US Fed Funds rate pushes further into negative territory. Solid commodity prices should provide a floor for the A$ though.
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