Market Update 22 March 2019

Investment markets and key developments over the past week

Share markets were mixed over the last week, with Asian markets up but US and Eurozone shares getting hit by growth worries on Friday. Japanese shares rose 1.6%, Chinese shares rose 2.4% and Australian shares rose 0.3%, but US shares lost 0.8% and Eurozone shares fell 2.1% in response to weak business conditions PMIs released on Friday. The combination of weak economic data and a very dovish Fed pushed bond yields sharply lower. While oil and gold prices rose, copper and iron ore prices fell and the A$ fell slightly against a flat US$.

How can shares rally and bond yields decline at the same time? Who is wrong? From their December lows to their recent highs, global shares have rallied around 18% and Australian shares have rallied around 14% but at the same time bond yields have fallen. This is not unusual. The same occurred in 2016, with shares bottoming around February and bond yields not bottoming till around July/August. It’s often referred to as being in the “sweet spot” in the cycle where shares rebound from being undervalued and as investors start to anticipate stronger growth helped by easier central banks, but bonds are still responding to news of low inflation and expectations of even lower interest rates for longer. This is exactly what we have seen since December. Bond yields may still have more downside but are likely to push up in the second half as global growth improves.

But what about the flat/inverted US yield curve? The collapse in bond yields though is now causing much consternation that a flattening or inversion of the yield curve in the US may be signalling a US recession. An inverted US yield curve – i.e. when long-term bond yields fall below short-term rates - has preceded US recessions so it’s natural for investors to be concerned. Last week saw the gap between the 10-year bond yield and the 2-year bond yield fall to just 0.12%, the gap between the 10-year bond yield and the Fed Funds rate fall to just 0.06% and the gap between the 2-year bond yield and the Fed Funds rate fall to -0.06%.

This is clearly a concern, given that past yield curve inversions have preceded US recessions. But there are several things to allow for. First, the yield curve can give false signals (circled on the chart) and the lags from an inverted curve to a recession can be around 15 months. So even if it becomes decisively inverted now, recession may not arrive till mid next year and historically the share market has peaked 3-6 months before recessions, so it would be too far away for markets to anticipate.

Second, various factors may be flattening the US yield curve which may not be indicative of an approaching US recession, including the Fed’s new-found dovishness, near-zero German and Japanese bond yields holding down US yields and high investor demand for bonds post the GFC as they have proven to be a good diversifier – rallying every time shares have a major fall.

Third, other indicators suggest that US monetary policy is far from tight – the real Fed Funds rate is barely positive, and the nominal Fed Funds rate is well below nominal GDP growth and both are far from levels that in the past have preceded US recessions.

So, the yield curve should be watched – particularly now it’s flashing amber – but its shortcomings need to be allowed for.

However, Friday’s falls in US and Eurozone shares, weak global PMIs, the risks around flattening/inverted yield curves and ongoing trade risks do highlight the significant risk of a correction in share markets after their deep V rebound from December lows. We still see stronger global growth in to the second half and this plus easy monetary conditions pushing share markets higher by year end, but in the short term they are long overdue a correction. And this would apply to Australian shares too even though they lagged global shares on the way up.

The conclusion of the Mueller probe into links between the Trump campaign and Russia may add to short term investor nervousness and the risk of a correction given fears that the Democrats may move to impeach Trump. However, based on recent indications it’s not clear that the probe has uncovered a “smoking gun” significant enough to convince House Speaker Pelosi to agree to start impeachment let alone whether its strong enough to convince 67 senators (including 20 Republicans) to support his removal from office.

Fed even more dovish both on rates and quantitative tightening. As expected, the Fed left rates on hold at its March meeting and while it revised down its growth forecasts a little bit it remains upbeat on the outlook and sees inflation staying around target. Consistent with its dovish tilt in January and inflation around target, the Fed remains “patient” on rates, its dot plot of rate hike expectations has been cut to no hike this year (from two hikes seen in December) with just one hike remaining next year and it has signalled that it will start slowing its balance sheet reduction (or quantitative tightening) from May and end it in September. In essence, the Fed sees growth around potential, inflation around target, unemployment around NAIRU and rates around neutral so there is less pressure to do anything. So for now, the Fed remains far less threatening for markets, but as we saw after a similar dovish tilt back in 2016 a return to a slightly more hawkish stance is a risk for later this year if as we expect US growth picks up again against the backdrop of a still tight labour market.

Getting closer to a US/China trade deal, but does this mean that Trump would open up a new trade war starting with auto tariffs on Europe? The past week saw ongoing argument around US/China trade negotiations particularly around when the US would remove the tariffs on imports from China, but this is to be expected. But a deal still looks likely as it’s in both sides interests and Trump continues to say that “the deal is coming along nicely”. But a deal with China would beg the question of whether Trump will then turn his attention to trade with Europe starting with auto tariffs. However, even though the Commerce Department is reported to have provided a rationale for tariffs to be imposed on auto imports on “national security” grounds and this may cause some market angst as Trump has to mid May to decide to or not, our assessment is that he probably won’t: the Commerce Department report looks like a negotiating stance with Europe; America’s trade deficit with Europe is small compared to that with China; public and Congressional support for a trade war with Europe is low; most of Trump’s advisers are against it; the EU would retaliate and this would badly affect states that support Trump that export to Europe; it would be a new blow to confidence and share markets ahead of Trump’s 2020 re-election campaign.

The Brexit comedy rolls on with the European Union giving PM May until April 12 to get her Brexit plan passed through the UK parliament on a third go (probably in the next week) or to seek a longer extension. While pressure on Brexiteers to support the deal is now intense it’s far from assured that it will receive parliamentary support. If it doesn’t, then the EU – not wanting to be blamed for a no deal Brexit - will likely accept a request for a longer extension, but it would probably be conditional on the UK voting in EU parliamentary elections in May, and it would likely mean that the whole thing could drag on for another year! Our view remains that a soft Brexit or no Brexit remains most likely but it’s a long way from being resolved. Because 46% of UK exports go to the EU but only 6% of EU exports go to the UK Brexit means far more for the UK economy that it does to the EU! What happens in the Eurozone is far more significant to us as investors than Brexit.

The Australian Federal Budget to be handed down on April 2nd will have three obviously overlapping aims: to provide a fiscal stimulus in the face of flagging growth; to reinforce the Government’s budget management credentials by keeping the budget on track for a surplus in 2019-20; and to help get the Government re-elected in a most likely May 11 or 18 Federal election. In all of this it has been helped by a revenue windfall mainly due to higher corporate tax receipts on the back of higher commodity prices (partly due to Vale’s problems in Brazil) but also higher personal tax collections due to stronger employment growth and lower welfare spending partly offset by reduced growth forecasts for 2019-20 and 2020-21. This is likely to see the budget running around $5bn better than expected in the December MYEFO for 2019-20. However, given the need for a fiscal boost and pre-election sweeteners the Government is likely to “spend” the bulk of the revenue windfall. We expect around an additional $3bn in personal tax cuts which along with the roughly $3bn pa already allocated for tax cuts in December’s MYEFO and the $3bn already legislated for following last year’s budget is expected to result in total personal income tax cuts of around $9bn from July – which are likely to be skewed towards low- and middle-income earners. There is also likely to be extra spending on health and infrastructure. Key Budget numbers for 2019-20 are expected to be: a budget surplus of around $5bn after budget handouts (or $10bn before any stimulus), real GDP growth of 2.5%, inflation of 2.25%, wages growth of 2.75% and unemployment of 5%.

The upside of the Australian Government’s Budget strategy is that the household sector will receive a boost just at the time it needs it given falling house prices and likely rising unemployment and of course a budget surplus is at last coming into sight after a record 11 years in deficit. The downside is that the tax cut boost to the household sector will like be small at around 0.5% of GDP, there is less assurance of a boost to the economy from tax cuts as opposed to “cheques in the mail” or increased government spending, the election means greater uncertainty about whether and when the stimulus will actually be delivered and the budget projections will come with a high level of uncertainty as the revenue boost from higher iron ore prices may prove temporary and slower economic growth will weigh on revenue. The stimulus is unlikely to be enough to head off the need for RBA rate cuts.

Major global economic events and implications

Business conditions PMIs in the G3 softened in March with the US composite PMI falling 1.2 points to a still reasonable 54.3, the Eurozone’s composite PMI falling to 51.3 and Japan’s manufacturing PMI remaining flat at a weak 48.9. While services conditions are holding up better, global manufacturing is clearly a lot weaker going through another downturn like that seen in 2015-16. This is all consistent with pressure remaining on policy makers to provide stimulus.

Apart from weaker business conditions PMIs, other US data was positive providing support to the view that while the March quarter may be weak, growth is likely to bounce back again. A home builders conditions index was flat in March, but current sales and expectations improved, manufacturing conditions in the Philadelphia region improved in March, the leading index rose more than expected in February, existing home sales rose strongly in February and jobless claims fell.

Japanese inflation was unchanged at 0.2% year on year in February with core inflation stuck at 0.4%. At least it’s not deflation but it’s a long way from the 2% inflation target so pressure remains on the Bank of Japan to remain ultra easy.

Australian economic events and implications

Australian jobs data added nothing to the debate about whether to cut rates or not. Unemployment fell, but this was due to reduced labour market participation. Employment slowed but this was after a huge surge in January so could just be noise. That said skilled job vacancies fell again in February consistent with falling ANZ job ads in pointing to slower jobs growth ahead. And the labour market is a lagging indicator. We see unemployment rising to 5.5% over the next year. There was a bit of good news with a rise in the CBA’s composite business conditions PMI for March, but this looks like normal volatility and at a reading of 50 it remains very weak.

Population growth remains strong – good for growth and good for underlying housing demand, but remember the focus should be on growth in GDP per person because that is more relevant for living standards. ABS data showed that population growth remained unchanged at a strong 1.6% over the year to the September quarter with 1 percentage point of that coming from migration and the rest from natural growth. Strong population growth naturally helps support demand in the economy and is a source of support for house prices (although a bunch of negative factors are dominating in the short term). But it also means that in Australia we have to have GDP growth in excess of 1.6% pa to grow GDP per person, whereas in Europe its just 0.2% and in Japan its -0.2% to do the same.

Why will limiting negative gearing and halving the capital gains tax discount push up rents and push down property prices? Several studies have looked at this issue with similar conclusions since it became part of Labor Party policy in 2016. The answer is quite simple. If negative gearing is limited and capital gains tax increased then investors will demand a higher pre tax return to invest in property. Looked at in rental yield terms (ie annual rents divided by prices) SQM Research – after examining international comparisons, what the tax changes would mean financially to taxpayers and the 1985-87 experience when negative gearing was briefly removed - estimate that rental yields are likely to rise around 1 percentage point over a 2-3 year period if the tax changes are made. This would occur via less investor demand in the property market causing some combination of lower property prices and rising rents (partly due to less property construction) until it becomes attractive to invest in property again. On their estimates average capital city property prices would fall 4% to 8% (but fall 7% to 12% in Sydney and fall 8% to 13% in Melbourne) and rents rise 7% to 12% in response over 3 years. Now this assumes two interest rates cuts and if that doesn’t occur the estimated fall in property prices is 5% to 12% relative to what otherwise would have occurred. A study last year by Riskwise Property Research and Wargent Advisory reached similar conclusions in terms of prices. Of course other things could reduce this impact like a new first home owners grant scheme and if rental yields have already increased anyway. Would property investors rush into the market ahead of the changes if they are confirmed so they can be grandfathered? Maybe. But they may also decide not to because they would worry that their investment property will be worth less once the tax changes occur. Regardless of the merits of such changes (for the record I think there is a strong case to reduce the capital gains tax discount but am less sure about the proposed change to negative gearing), this issue is another drag on the residential property price outlook.

What to watch over the next week?

In the US, data releases are expected to show a fall back in housing starts after January’s surge, but continued modest gains in home prices and a slight further rise in consumer confidence (all due Tuesday), a slight improvement in the trade balance for January (Wednesday), a downwards revision to December quarter GDP growth (Thursday) from 2.6% annualised to 2.4%, a fall in pending home sales (Thursday) but a rise in new home sales (Friday), a modest gain in January consumer spending (also Friday) along with core private consumption deflator inflation staying at 1.9% year on year.

Eurozone economic confidence data for March to be released Thursday will be watched for signs of stabilisation after falling over the last year and core inflation (Friday) is likely to have remained stuck around 1%yoy.

Japanese jobs data for February (Friday) is likely to have remained strong but industrial production is likely to bounce.

In Australia, ABS job vacancy data for February due Thursday is expected to show some signs of softening consistent with the ANZ job ads survey, and private credit growth (Friday) is likely to have remained modest in February with housing investor credit remaining weak. Public addresses by RBA officials Ellis and Kent on Tuesday and Wednesday will be watched for any clues on the interest rate outlook.

Outlook for investment markets

Share markets – globally & in Australia - have run hard and fast from their December lows and are vulnerable to a short-term pullback. But valuations are okay, global growth is expected to improve into the second half of the year, monetary and fiscal policy has become more supportive of markets and the trade war threat is receding all of which should support decent gains for share markets through 2019 as a whole.

Low yields are likely to see low returns from bonds, but they continue to provide an excellent portfolio diversifier. Expect Australian bonds to outperform global bonds.

Unlisted commercial property and infrastructure are likely to see a slowing in returns over the year ahead. This is particularly likely to be the case for Australian retail property.

National capital city house prices are expected to fall another 5-10% into 2020 led again by 15% or so price falls in Sydney and Melbourne on the back of tight credit, rising supply, reduced foreign demand, price falls feeding on themselves and uncertainty around the impact of tax changes under a Labor Government.

Cash and bank deposits are likely to provide poor returns as the RBA cuts the official cash rate to 1% by year end.

The A$ is likely to fall into the US$0.60s as the gap between the RBA’s cash rate and the US Fed Funds rate will likely push further into negative territory as the RBA moves to cut rates. Being short the A$ remains a good hedge against things going wrong globally.