Investment markets and key developments over the past week
The past week saw financial markets dominated yet again by geopolitical developments with first the turmoil in Italy and then US trade announcements rattling share markets, but with good US payrolls and the formation of an Italian government helping boost US and Eurozone shares on Friday. For the week this left US shares up 0.5%, but Eurozone shares down 1.4%, Japanese and Chinese shares down 1.2% and Australian shares down 0.7%. While bond yields rose late in the week they ended down slightly in most major countries except in Italy. Commodity prices were mixed with copper up slightly but oil and iron ore down. Despite the volatility in markets the A$ rose slightly with the US$ little changed.
Trade war worries back to the fore again with Trump announcing that tariffs and investment restrictions on China will be formalised on June 15 and 30 respectively and start soon thereafter and that US exemptions for the EU, Mexico and Canada to the steel and aluminium tariffs announced earlier this year are ending. These moves are concerning and heighten the risk of a global trade war, but both need to be put in some context. First, the measures regarding China are the same as those flagged on March 22nd which were due to be formalised by May 22nd but were then put on hold after the start of successful negotiations with China two weeks ago. Trump appears to be taking a tough stance again to nullify domestic criticism he has gone too easy on China, but it also looks like a negotiating tactic designed to get more out of China ahead of another round of talks. The risk is that China feels it can no longer trust Trump. But solving this issue was never going to be smooth, it will take time and Trump’s volatile nature along with divisions on the US side will continue to add to noise.
Second, the commencement of tariffs on steel and aluminium from the EU, Mexico and Canada is (like all protectionism) dumb economics particularly at a time when the US is already operating at close to full capacity. But it’s worth putting all these tariffs in context: steel & aluminium imports are less than 2% of US imports (and less than that is affected as many countries including Australia are exempted) and $50bn of Chinese imports are also less than 2% of US imports so taken together it’s a non-event compared to the 1929 or 1971 tariff hikes of 20% and 10% respectively that covered most imports. A proportional response is expected on steel and aluminium but it’s only going to have a significant global economic impact if it triggers multiple rounds of tit for tat tariff hikes across a broad range of products. The bottom line is that while the risks have escalated we are still a long way from a full-blown trade war globally and Trump is likely wary of pushing too hard here for fear of a backlash from US workers who will have to pay more at Walmart and see their jobs go at Harley Davidson, Boeing, etc.
Early election averted in Italy with the Five Star Movement and Northern League forming government, but it’s likely to remain messy. The Finance Minister may not be so anti-Euro but the agenda for fiscal expansion and hence the likelihood of conflict with the European Union remains high. As a result, Italian bonds and shares are likely to remain under pressure for a sometime yet as investors fear that the ECB won’t be able to support Italian bonds, the economic outlook deteriorates, and they worry that their investments will fall in value if Italy exits the Euro. Uncertainty about Italy is likely to continue to weigh on the Euro and Eurozone shares and as we saw with the Eurozone debt crisis a few years ago this can also weigh on global and Australian shares at times because it raises concerns about growth in the world’s third largest economic block after the US and China. So Italy at just 1.9% of global GDP can have an outsized impact on markets just like Greece at just 0.3% did during the Grexit crises.
However, two things are worth noting. First, ultimately Italy is likely to remain in the Euro because it’s too hard to leave given it would involve a sharp collapse in the value of a “new” Lira, a run on the banks, capital flight and a further sharp rise in Italian bond yields and a majority of Italians support it. But as we saw with Greece and Syriza a few years ago it can take a while (and a sharp rise in Italian bond yields) to get to this point. Second, the risk of contagion to other countries like Spain, Portugal, Ireland and Greece is now low given they are seeing stronger economic conditions, lower unemployment and reduced budget deficits and popular support for the Euro is high across Eurozone countries at over 70%.
Spain is no Italy - the change of government in Spain to one led by the centre left Socialists, does not threaten Spain’s commitment to the Euro. The Socialists are pro-EU and the Euro and given political constraints will honour the Rajoy government’s budget that was recently passed. Even if the new government fails and there are early elections the Citizens Party or Ciudadanos would gain the most and it also supports the Euro. Along with the People’s Party these three pro Euro parties garner two thirds popular support and the eurosceptic Podemos only gets around 17% support. So forget about any “contagion” from Italy to Spain.
Trade wars, Itexit fears and the investment cycle. A big debate in the investment world is always about where are we in the investment cycle. This is particularly the case at present in relation to the US economy and share market where the cycle is more mature. A normal cycle would see growth continue at high levels, spare capacity recede and inflation and other signs of excess continue to build driving monetary policy ultimately into tight territory and setting the scene for the next major bear market and economic downswing. However, as we have seen ever since the GFC this has all been a long time coming as various events have slowed the build-up in growth and excesses. Geopolitical shocks such as a trade war or an escalation of worries around an Itexit could have the same impact in cooling growth, pushing bond yields back down and ultimately extending the day of reckoning for the global economic upswing.
Major global economic events and implications
Another week of strong US data. Consumer confidence remains about as high as it ever gets, personal spending growth was solid in April, home prices are continuing to rise, the ISM manufacturing conditions index rose to an even stronger level in May, construction activity is rising solidly, the goods trade deficit unexpectedly improved in April and labour market data remains strong. May saw another “Goldilocks” jobs report with payrolls up a stronger than expected 223,000 and unemployment falling to 3.8% which is its lowest since 1969 but wages growth only edging up to 2.7% year on year. The April core private final consumption deflator was unchanged at 1.8% year on year but is running at 2% on a 3- and 6-month annualised basis which is right on the Fed’s inflation target. This is all consistent with the Fed continuing to raise interest rates with the next move this month and we still see a total of four hikes this year.
Eurozone economic sentiment slipped in May, but it’s still strong. Meanwhile unemployment came in at 8.5% in April which was down from 8.6% in March and May core inflation bounced back to 1.1%yoy. Italian risks may not stop the ECB from starting to taper its quantitative easing program in the December quarter, but it adds to confidence that it will not be raising interest rates until the second half next year at the earliest.
Japan saw strong labour market data and a rise in consumer confidence but weaker than expected production.
Chinese business conditions PMIs for May were flat or rose a bit consistent with continuing solid growth.
Indian March quarter GDP growth came in at a strong 7.7%yoy – surpassing China’s growth rate of 6.8%yoy.
Australian economic events and implications
Australian economic data was on the soft side with a fall in building approvals, continuing moderate credit growth, a continuing fall in home prices and a softer than expected rise in business investment for the March quarter. Investment plans are showing improvement, but it’s gradual with investment plans for 2018-19 only up 1.4% on those for 2017-18. At least they are no longer plunging though, so the drag on growth from investment is over.
Capital city dwelling prices continued to slip in May falling by 0.2% month on month and 1.1% year on year. Prices have now fallen for seven months in a row and Sydney is continuing to lead the way down. Our assessment remains that home prices in Sydney and Melbourne have more downside ahead thanks to tightening bank lending conditions, rising supply, falling capital growth expectations causing buyers to hold back and slowing foreign buying. In the absence of much higher unemployment or higher interest rates, price declines are likely to remain gradual and this is also consistent with auction clearance rates which have slowed but not collapsed. Our expectations are for Sydney and Melbourne prices to fall 6% or so this year, another 5% next year and around 2-3% in 2020. Prices in Perth and Darwin look close to the bottom and moderate growth is expected in other capitals. Overall, Sydney and Melbourne are likely to see a top to bottom fall of around 15% spread out to 2020, but for national average prices the top to bottom fall is likely to be around 5%.
The increase in the minimum wage by 3.5% from July will help wages growth, but only a bit. This increase is only fractionally stronger than last year’s 3.3% rise which helped wages growth tick up from 1.9% to 2.1%. With unemployment and underemployment remaining very high at around 14% it’s hard to see underlying wages growth picking up much so our guess is that the 3.5% minimum wage increase will just help keep wages growth ticking along at 2.1%. Pumping up minimum wages won’t jump start stronger underlying wages growth because to get that we need to see a much tighter labour market and that needs stronger growth. The risk is that it makes low income workers relatively less attractive further boosting automation and offshoring.
What to watch over the next week?
In the US, it will be a relatively quiet week on the data front but expect the May non-manufacturing conditions ISM index (Tuesday) to remain strong at 56-57, job opening and hiring data for April (also Tuesday) to have remained very strong and the trade deficit for April (Wednesday) to improve slightly.
Chinese trade data for May (Friday) is expected to show export growth remaining solid at around 10% year on year but import growth slowing back to around 12% yoy. Inflation data will also be released Saturday but should be benign.
In Australia, the RBA is expected to leave interest rates on hold for a record 22 months in a row when it meets Tuesday. While the RBA would no doubt like to be raising rates to more normal levels like the Fed is and continues to repeat the mantra that the next move is more likely to be up than down there is currently no case to move rates. Booming infrastructure investment, better non-mining investment, strong export growth and the RBA’s own forecasts for growth and inflation all support the case for an eventual rise in rates but this is counterbalanced by uncertainty around consumer spending, weak wages growth and inflation, tightening bank lending standards and the slowing Sydney and Melbourne property markets. Our view remains that a rate hike is unlikely until 2020 at the earliest and that in the interim a rate cut cannot be ruled out.
On the data front in Australia the main focus will be on March quarter GDP growth (Wednesday) which is expected to come in at 0.8% quarter on quarter or 2.7% year on year thanks to a 0.6 percentage point contribution from net exports after several weak quarters and strong public demand offsetting soft growth in consumer spending. In other data expect a 0.1% rise in April retail sales (Monday), continued strength in services conditions PMIs (Tuesday) and a slight fall in the trade surplus (Thursday) to $1.3bn.
Outlook for markets
Volatility in share markets is likely to remain high as US inflation and interest rates move up and as issues around President Trump (trade, Mueller inquiry, etc) continue to impact, but the medium-term trend in share markets is likely to remain up as global recession is unlikely and earnings growth remains strong globally and solid in Australia. We continue to expect the S&P/ASX 200 Index to reach 6300 by end 2018.
Low yields and capital losses from rising bond yields are likely to drive low returns from bonds. Australian bonds are likely to outperform global bonds helped by the relatively dovish RBA.
Unlisted commercial property and infrastructure are still likely to benefit from the search for yield, but it is waning, and listed variants are vulnerable to rising bond yields.
National capital city residential property prices are expected to slow further as the air continues to come out of the Sydney and Melbourne property boom and prices fall by another 4% this year, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms.
Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.
The A$ 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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