Investment markets and key developments over the past week
US equity markets continued to track higher over the week, continuing the positive trend since the beginning of the year with the S&P500 up 0.9%. Euro stocks were 1.0% higher, Japanese equities rose by 0.7%, Chinese shares were 1.4% higher while Australian shares lagged behind, and were down by 1.1%.
Positive gains in US shares have occurred despite an increase in US bond yields (the 10-year up is above 2.65%) and a US government shutdown, which occurred at midnight Friday (US time). The US Senate failed to approve a “continuing resolution” legislation to keep funding government departments after the House of Representatives passed an extension on funding earlier in the day. The debate between Republicans and Democrats was over legislation around illegal immigrants (the “Dreamers” who came to the US as children) and border security. So far, there has been minimal impact on financial markets. The US dollar was a little stronger on Friday, but still weaker over the week.
What happens next? The last time a government shutdown occurred in the US was in October 2013 and it disrupted activity in the short-term, but there were no long-term impacts. This time, the impacts have been limited so far because it is expected that there will be a resolution in talks imminently, which means minimal disruption to the economy. Another vote is scheduled for the early hours of Monday morning (Washington time).
A shutdown means that essential government functions will continue (defence, security, post) but non-essential functions will not operate until the shutdown is resolved. Numerous government workers won’t get paid initially, but they will be back-paid after the continuing resolution is passed. While in previous shutdowns, national parks and public tourist attractions were closed, this time round it appears that national parks may still remain open. Some economic data releases may also be delayed.
So, while a shutdown is not ideal, it’s unlikely to last long and won’t have negative long-term implications. However, the longer the shutdown goes on, the more negative it will be for equities in the short-term. The issue around lifting the debt ceiling is also coming up and needs to be voted on in February. This is more important than a government shutdown risk because of the need to keep paying US debt. Investors also need to keep in mind that a potential full spending package (when it is finally agreed upon) could contain additional packages for higher defence and infrastructure spending which would be positive for markets.
US reporting season is underway and so far, companies have reported good results for the fourth quarter, even though expectations for earnings were already high. Earnings growth is expected to be up by 12% over the year for the fourth quarter. The energy sector, in particular, has had large upgrades. Companies have been reporting positive benefits from tax cuts.
Although some of the positivity from tax cuts has already been priced into markets, we think that the impact on households has not been fully considered as most will receive a tax cut. Households might believe that they are better off once their pay cheques are adjusted from mid-February.
Major global economic events and implications
The US beige book, which collates information about economic conditions across the various individual Federal Reserve districts showed good conditions across the districts. The outlook is still positive and most districts reported some labour market tightness. Although there have been numerous signs of labour market constraints, the wage data is not budging higher. The latest Atlanta Fed wages tracker showed a dip in wages growth (see chart below) which does look odd.
Other US data showed housing starts and permits were down in December. However, the Bloomberg consumer confidence index reached its highest reading this week since March 2001 and industrial production was up by 0.9% in December.
Chinese fourth quarter gross domestic product (GDP) beat market expectations. In 2017, Chinese GDP rose by 6.9% (above 6.7% in 2016). The outlook for China is still slower growth, as policymakers aim to tighten financial conditions, reduce corporate debt and focus on improving pollution levels. Retail sales were up by 9.4% in December, and industrial production was up by 6.2%. Investment growth was strong in December, up by 7.2%.
The Bank of Canada hiked interest rates, as expected by 0.25%, taking interest rates to 1.25%. The central bank is optimistic about the outlook and inflation is close to the target. However there are concerns about the future of the North American Free Trade Agreement (NAFTA) and its impact on Canada. The next rate hike is expected by markets to occur in April.
In Germany, the centre-left Social Democrats (SPD) conference led to a good outcome, with delegates voting to move ahead with formal coalition talks with Angela Merkel’s conservative Democratic Union. This is a positive sign that a grand coalition will be able to form in Germany which will bring stability to politics in Germany and the eurozone after the German election was held in September 2017.
Australian economic events and implications
It was a good week for Australian data. The labour market continues to boom, with jobs lifting by 34,700 in December, taking employment growth to 3.3% - the strongest rate of employment growth since 2008. The unemployment rate rose slightly to 5.5% (from 5.4%) in December due to the participation rate lifting, which is a sign that more people are moving back into the workforce. Employment growth is still expected to remain strong over the next few months, but the pace of growth will weaken (to around 2.5% on an annual basis). Now we just need to see wages growth lift! Consumers are still feeling confident though, with confidence up again in January, which is closing the previous wide gap between business and consumer confidence (see chart below).
Housing lending was up by 2.3% in November, with loans to owner-occupiers and investors up. The overall trend in housing lending growth is slowing, but only gradually.
What to watch over the next week?
The Bank of Japan (BoJ) meets as does the European Central Bank (ECB). Both central banks are still pursuing easy monetary policy settings through their asset purchasing programs. No changes to interest rates are expected from the BoJ or ECB next week, or for the rest of the year. In Japan, inflation is still well below the central bank’s 2% inflation target. Japanese inflation data is due out next week, with consensus expecting annual core inflation at 0.4%. The January manufacturing PMI is also out.
Despite strong eurozone growth in 2017, core inflation is not meeting the ECB’s 2% target. The high euro will not help near-term growth. Nevertheless, the ECB’s latest communication indicates that it is starting to think about when tighter policy will be needed in the eurozone. Asset purchases are due to continue until September this year, after which time we don’t expect an extension of the asset purchase program. However, rate hikes aren’t likely until next year. The January manufacturing PMI is also released, and is still expected to remain over 60 – which is very strong.
US fourth quarter GDP should show annualised growth of 2.9% which would be a little weaker than the third quarter at 3.2%, though is still a strong outcome. December durable goods orders, a good signal for capital expenditure, should show another rise while the January manufacturing PMI might weaken on the prior month but still remain at a high level.
New Zealand fourth quarter consumer price data is expected to show unchanged inflation running at 1.9% over the year.
There is a sixth round of NAFTA negotiations from 23 28 January. We doubt that the US will actually withdraw from the trade agreement, although there is a decent chance that Trump will issue a “notice of withdrawal” from the agreement that will not mean the US will actually leave the agreement but it will be used as a negotiating tactic. Either way, the share market wouldn’t take the news well. Trump does seem to be softening his stance on NAFTA, compared to the pre-election rhetoric.
Outlook for markets
Continuing strong economic and earnings growth and still easy monetary policy are positive for shares. However, markets have had an exceptional run-up (especially in the US), valuations are looking stretched and sentiment is at extremes so the risk of a correction in equities over the next few months is high. We continue to favour Europe (which remains very cheap) and Japan over the US. There are plenty of political risks coming up which might also spook markets. Australian shares are likely to do okay with moderate earnings growth, but still lag the rest of the world.
Commodity prices are likely to push higher in response to strong global growth.
Low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds.
Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors.
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%, whilst 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 a further short-term bounce higher, the A$ is likely to fall to around US$0.70, but with little change against the yen and the euro, as the gap between the Fed funds rate and the Reserve Bank of Australia’s cash rate goes negative. Solid commodity prices will provide a floor for the A$ though.
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