Investment markets and key developments over the past week
While share markets fell earlier in the week on the back of trade and growth worries, they then rebounded helped on Friday by reports of the US Federal Reserve (the Fed) considering ending its quantitative tightening program earlier than expected and a temporary end to the US partial government shutdown. This left US shares down 0.2% for the week, but Eurozone shares rose 1.1%, Japanese and Chinese shares rose 0.5% and Australian share rose 0.4%. Bond yields fell, helped by a dovish ECB. While the oil price rose on Friday, as political conflict risks disrupting Venezuelan oil production, it fell over the week. Gold and metal prices rose but the iron ore price fell. While the US$ fell on talk of quantitative tightening (QT) ending early, the A$ was little changed, held down by increasing expectations of lower interest rates in Australia.
More signs of a dovish turn at the Fed, with reports that it is considering ending its quantitative tightening (QT) program, or balance sheet reduction, at an earlier level than previously expected. When the Fed started to reverse its quantitative easing program back in October 2017 by not reinvesting all of the proceeds of maturing bonds, it was thought the run-off in its bond holding (or QT) would continue until the Fed’s balance sheet had fallen from around US$4.5 trillion to around US$2-3 trillion, which would have taken until around late 2020 or early 2021 at least. But now the Fed looks to be reassessing what the appropriate level of bank reserves is, and this may imply an appropriate level for its balance sheet of around say $3.5 trillion, which would be reached early next year and imply an end to QT by then. So much for being on “auto-pilot”! It’s likely that the Fed will sooner or later make a formal reference to this, possibly as early as after Wednesday’s Fed meeting. This is likely to be a marginal positive for markets to the extent that the withdrawal of liquidity associated with QT may have been one factor in last year’s share market weakness.
The US partial government shutdown has now also ended - at least for three weeks. This is not a permanent resolution as funding for President Trump’s wall has not been resolved so the shutdown could start up again after 15th February. But the three-week reopening will allow public sector workers to be paid and keep airports and border security going, and so it will minimise (for now) the impact on the economy. While the tension between Trump and the Democrats in Congress remains intense, the deal to reopen - and the fact that it was achieved without any “down payment” on Wall funding - shows Trump is sensitive to the impact on the economy. The same applies to the trade issue with China and the coming need to raise the debt ceiling. The five-week shutdown was a record, but since it was only 25% of government it was equivalent to 8.5 days of a full shutdown in terms of its macro-economic impact (versus say the 16 day shutdown in 2013). That said, for an affected public servant five weeks without pay is five weeks and it must have been pretty painful for many!
The IMF catches up to markets. While the IMF revised down its 2019 growth forecast from 3.7% to 3.5% and its 2020 global growth forecast from 3.7% to 3.6% and warned of threats to global growth, there was nothing new here. As usual the IMF is just catching up to the slowdown in global growth seen last year and the falls seen in share markets. That said, the return to the post-GFC norm of growth downgrades (where global growth forecasts start near 4% and end near 3%) reminds us that we have still yet to escape the caution and fragility that has characterised the post-GFC period. This is clearly a threat, but it also keeps inflation down and monetary policy easy which is a positive for investment markets.
Business conditions PMIs indicate that the global growth slowdown has continued into January. While January “flash” PMIs rose in the US, they fell in Europe, Japan and Australia. See the next chart. This will maintain pressure for global policy easing.
Our view remains that shares will do better this year, thanks to much improved valuations, likely policy support and a stabilisation and improvement in global growth. But after a huge rebound since the December lows, shares are vulnerable to a short-term pull back/re-test of December lows in the face of a long worry list. Things that would get us more bullish from here regarding the short term are: a successful retest of the December lows or technical support levels, stimulus in China getting the upper hand, confirmation of an easier Fed, ECB easing, continuing progress in US/China trade talks, a decisive end to the US government shutdown and signs the US debt ceiling will be raised relatively smoothly, a bottoming in profit revisions and good earnings reporting seasons globally and in Australia, stronger than expected economic data and a bottoming in PMIs and share markets breaking through resistance on strong breadth. We are making some progress on these and we don’t necessarily need to see all of them, but we do have a way to go yet.
A “no deal” Brexit continues to look unlikely. As we pointed out last week, parliamentary support for a “no-deal” or hard Brexit is very low (at maybe just 10% of parliament) and signs of bipartisan support to extending the Brexit deadline if agreement is not reached just adds to confidence we will see either a “soft” Brexit or no Brexit as opposed to a “no deal” Brexit. Reports that Democratic Unionist parliamentarians from Northern Island will support May’s plan are positive, but there is a long way to go though and the uncertainty is not helping the UK economy.
In Australia, the decision by NAB to catch up to last year’s mortgage rate increases put through by other banks highlights ongoing funding cost pressures faced by the banks on the roughly 35% of their funding that they get outside of bank deposits. With short term funding costs rising sharply again in recent months (as evident by a rise in the spread between the 90-day bank bill rate and the expected cash rate to around 60 basis points compared to a norm of around 23 basis points) pressure remains on the banks, putting ongoing upwards pressure on mortgage rates, resulting in a de facto monetary tightening. Coming at a time when households with a mortgage are being adversely affected by falling home prices in Sydney and Melbourne, it’s consistent with our view that the RBA will lower the cash rate this year.
Major global economic events and implications
Several US data releases were postponed over the last week thanks to the shutdown, but what was released was mostly good. Existing home sales fell sharply, and the leading index fell in December (although this was due to the share market fall), but against this the Markit composite business conditions PMI rose marginally in January to a solid reading of 54.5, jobless claims fell to a 49-year low and home prices continue to rise.
The US December quarter earnings reporting season is actually coming in reasonably good. 113 S&P 500 companies have reported so far with 73% beating on earnings with an average beat of 1.7% and 58% beating on sales. Earnings growth is running at 15.8% year-on-year for the quarter.
As widely expected, the ECB left monetary policy unchanged, but its acknowledgement that the risks to growth are on the downside opens the door to more monetary easing ahead with President Draghi reiterating that all the ECB’s tools are on the table. Our assessment is that the ECB will announce another round of cheap bank funding (or LTROs) at their March meeting and a rate hike is years away. Another slide in Eurozone business conditions PMIs in January indicates that growth is continuing to slow.
Similarly, the Bank of Japan made no change to its monetary stimulus, keeping the pedal as it revised down its inflation outlook. Japan’s business conditions PMI also fell sharply in January warning of slower growth.
No surprises from Chinese data – growth is slowing but not collapsing. December quarter GDP growth came in at 6.4% year-on-year which left 2018 growth as a whole at 6.6%, which was actually a little bit stronger than our expectation for 6.5% growth. Meanwhile, growth in industrial production and retail sales actually perked up a bit and while unemployment rose to 4.9% from 4.8% it’s in the same range it’s been in for a year. Nevertheless, growth is still likely to slow a bit further - as exports fall after frontloading to avoid tariff hikes - necessitating more policy stimulus. Consistent with this, the PBOC further eased up credit conditions by allowing investors to swap some bonds of state-owned enterprises for central bank bills for use as collateral. We expect Chinese growth this year of 6.2%.
Australian economic events and implications
Australian jobs up but house prices down. Labour market data for December presented a mixed bag with better than expected jobs growth and a fall in unemployment back to 5%, but a fall in full time jobs, a further slowing in annual jobs growth and still high underemployment. Forward looking labour market indicators remain solid but have lost some momentum. Consistent with this, the CBA’s business conditions PMI fell further in January, continuing the downtrend since March 2017.
Meanwhile, data from Domain confirmed that property prices continued to slide in the December quarter, driven by the once booming cities of Sydney and Melbourne as a combination of negative forces impact led by tight credit, rising supply and falling prices feeding on themselves. We now see Sydney and Melbourne home prices falling another 15% or so this year as part of a total top to bottom fall of 25%, which with broadly stable prices elsewhere will see national average prices fall another 5 to 10% this year. What’s driving the falls is well known, but what will cause the downswing to bottom out? It’s a while off yet but we expect a combination of RBA rate cuts flowing to lower mortgage rates, improved affordability thanks to lower prices, continuing strong population growth, the prospect of slowing new supply and possibly some form of Government support (like a new round of Federal First Home owner grants) to help prices stabilise next year.
What to watch over the next week?
Globally the Fed on Wednesday and continuing US/China trade talks (with Vice Premier Liu He travelling to the US for talks on Wednesday and Thursday) will likely dominate, whereas in Australia the focus will be on December quarter inflation data to be released on Wednesday.
Our expectation is that the Fed will leave interest rates on hold and repeat the “patient” and “watching” message of late, supporting expectations for an extended pause in rate hikes and flexibility to do whatever it can to keep the expansion going. It may also provide some comments consistent with ending quantitative tightening (QT) earlier than had previously been expected. The trade talks are expected to make further progress – but it looks like there is still a long way to go in terms of the structural issues with plenty of potential for periodic upsets, albeit we remain of the view that a solution will be reached in the months ahead.
With the US shutdown now ended (at least for three weeks) some of the backlog of postponed US data – including retail sales, housing starts, trade and durable goods orders – will likely start to trickle out in the weeks ahead. In terms of what is scheduled to be released in the week ahead, expect to see a slight dip in consumer confidence (Tuesday), December quarter GDP (Wednesday) to rise 2.6% annualised, inflation as measured by the core private consumption deflator for December (Thursday) to remain at 1.9% year-on-year, employment costs in the December quarter (also Thursday) to have risen 2.9% year-on-year, the January ISM manufacturing conditions index (Friday) to stay around 54 and January jobs data (Friday) to show a solid 160,000 gain in January payrolls (after the huge 312,000 gain in December), unemployment to fall to 3.8% and wages growth to remain around 3.2% year-on-year. The US earnings reporting season will also ramp up with Apple, Microsoft, Facebook, Amazon, GE and Exxon reporting.
Eurozone December quarter GDP growth (Thursday) is expected to show growth stuck around 0.2% quarter-on-quarter, which will see annual growth slow further to 1.2% year-on-year. Meanwhile, economic confidence (Wednesday) is likely to have slipped again in January, December unemployment (also Thursday) is likely to have remained at 7.9% and core inflation for January (Friday) is expected to remain at 1% year-on-year. All of which is consistent with more ECB stimulus.
Japanese data is expected to show a slight fall in industrial production (Thursday) but continuing solid labour market indicators (Friday).
China will release business conditions PMIs for January on Thursday and Friday which are likely to remain just below 50 for manufacturing but around 53 to 54 for services.
In Australia, we expect headline and underlying inflation for the December quarter (Wednesday) of around 0.5% quarter-on-quarter or 1.8% year-on-year. Underlying inflationary pressures are likely to remain weak and falls in petrol prices and health costs are likely to have been offset by an increase in tobacco excise. Meanwhile, expect the NAB business survey (Tuesday) to show a further fall in confidence, credit growth (Thursday) to remain modest and CoreLogic data for January to show a further fall in home prices (Friday). The Banking and Finance Royal Commission report will also be delivered to the Government on Friday and amongst other things will be watched in terms of its implications for bank lending.
Outlook for investment markets
With uncertainty likely to remain high around the Fed, US politics, trade and growth, volatility is likely to remain high in 2019 but ultimately reasonable global growth and still easy global monetary policy should drive better overall returns than in 2018 as investors realise that recession is not imminent:
Global shares are likely to see volatility remain high, with the high risk of a re-test of December 2018 lows, but valuations are now improved, and reasonable growth and profits should support decent gains through 2019 as a whole, helped by more policy stimulus in China and Europe and the Fed having a pause.
Australian shares are likely to do okay but with returns constrained by moderate earnings growth.
Low yields are likely to see low returns from bonds, but they continue to provide an excellent portfolio diversifier.
Unlisted commercial property and infrastructure are likely to see a slowing in returns over the year ahead. This is likely to be particularly the case for Australian retail property.
National capital city house prices are expected to fall another 5-10% this year led again by 15% or so price falls in Sydney and Melbourne on the back of tight credit, rising supply, reduced foreign demand 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 end 2019.
Beyond any further near-term bounce as the Fed moves towards a pause on rate hikes, the A$ is likely to fall into the US$0.60s as the gap between the RBA’s cash rate and the US Fed Funds rate will still likely push further into negative territory as the RBA moves to cut rates. Being short the A$ remains a good hedge against things going wrong globally.
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