Investment markets and key developments over the past week
After several weeks of gains, share markets were mixed over the last week as the attack on Saudi Arabian oil production provided a reminder of risks in the Middle East, trade war pessimism returned on Friday, global economic data was mixed and the US Federal Reserve (the Fed) cut rates again. For the week, US shares fell 0.5% due to another trade war flare-up late on Friday, Eurozone shares rose by 0.1%, Japanese shares rose 0.4% and Chinese shares fell 0.9%, not being helped by weak economic data. Australian shares rose 0.9%, led by energy shares on the back of higher oil prices and are just 1.7% below their July all-time high. Bond yields fell as the Saudi attack and the latest trade war flare-up provided a reminder that the risks to the outlook remain significant. Oil prices rose but reversed much of the spike seen early in the week. Metal and iron ore prices fell. The A$ fell back below US$0.68 on the back of dovish RBA minutes and rising unemployment.
Rising unemployment and dovish RBA minutes point to an October rate cut. We were already expecting the next cut to come in October but two developments over the last week have seen the money market move the probability of a cut up from 22% a week ago to 80% now. Firstly, the minutes from the last RBA board meeting were more dovish in dropping the requirement for an “accumulation of evidence” before another easing and noting that its liaison program showed that retailers are yet to benefit from the tax cuts and that the uptrend in wages growth looks to have stalled. Secondly, and more importantly, while jobs growth in August was strong the quality was poor, with falling full time jobs and both unemployment and underemployment rising further, which makes it very hard to see a pick-up in wages growth anytime soon. In fact, job vacancies and hiring plans point to slowing jobs growth ahead and hence even higher unemployment. All of which will be impossible for the RBA to ignore. As a result, we continue to see the next 0.25% cut coming in October followed by another cut in November, ultimately taking the cash rate down to 0.5%. Interestingly, RBA Governor Lowe is scheduled to speak at a business community dinner after October’s board meeting just as he did after the June and July meetings when rates were cut!
Oil was a big issue over the last week, but it quickly faded (at least for now). While oil prices spiked on news of the attack on Saudi Arabian oil production which impacted 6% of world oil supply, they have settled back to be only up $3-4 a barrel from their pre-attack levels as Saudi production looks to be returning to normal relatively quickly. To be a major problem for global and Australian economic growth, past experience suggests oil prices need to at least double. Right now, we are nowhere near that with oil prices down from levels a year ago (see the next chart). It’s also worth noting that the amount of oil used to produce a unit of global GDP has halved over the last 30 years, meaning that the world is now far less sensitive to oil price moves. Key to watch now will be whether there are more attacks and whether Saudi/US retaliation further escalates the conflict. Trump’s backdown from “locked and loaded” to “I don’t want war with anybody” and later in the week “I think restraint is a good thing” is a positive sign. But there is a long way to go before this issue is resolved. For Australia, a doubling in world oil prices would take the average petrol price to around $1.95 a litre and that would knock nearly $20 a week off average household spending power and be a problem for the economy. But we are a long way from that. In fact, the US$3-4 a barrel rise in world oil prices over the last week would only justify a 3-4 cent a litre rise in petrol prices and then only with a lag as the more expensive fuel flows through. Average capital city petrol prices are up about a 1-2 cents from a week ago which just looks like noise.
Trade war noise continues, with President Trump criticising China and saying he’s not interested in “a partial deal” and China cancelling a US farm visit. Perhaps President Trump is feeling emboldened again after a few weeks of US share market gains and some better US economic data. I expect trade war argy-bargy and noise to continue for some time yet, but at least some sort of de-escalation is likely ahead of the US presidential election.
Fed cuts rates by another 0.25%, more cuts likely. While the Fed remains optimistic, its latest cut continues to take out insurance against the threat posed by the trade war and slower global growth to the US economy at a time when inflation remains low. Given that the risk to the outlook – from trade and Iran tensions - won’t dissipate quickly, we continue to see another Fed rate cut by year-end. Meanwhile, Fed Chair Powell ruled out taking US rates negative should interest rates have to go back to zero. So, forget about negative rates in the US at least for the foreseeable future. The same likely applies in Australia.
Liquidity stresses in the US money market unlikely to be a major problem. There has been a lot of talk about this over the last week, following spikes in the so-called repo rate (i.e. very short-term money market rates). This was due to a combination of corporate tax payments, a lot of Treasury debt issuance to fund the bigger US budget deficit and the impact of quantitative tightening which has reduced bank reserves, all of which drained cash from the short-term money market. It’s very different to the sort of counterparty confidence issues that caused big problems in the GFC. So Fed Chair Powell is probably right in saying “we are not worried” as the Fed addresses the problem by injecting funds into the money market (via repurchase agreements) and it lowered the interest rate it pays on excess bank reserves to encourage banks to lend out more. It’s also looking at (and likely to adopt) a longer-term solution which would see its balance sheet grow again (by injecting funds into the economy and buying bonds) to allow for growth in the economy. This is not really QE because it’s basically liquidity management (as opposed to macro-economic policy) and is much smaller – but some might call it that. So far there is little evidence that the spikes in US short-term funding costs are having much impact in Australia – the gap between 3-month bank bill rates and the expected official cash rate has risen but is below normal levels.
Major global economic events and implications
US data was actually pretty good. While the leading index was flat in August and manufacturing conditions were soft in the New York region, they were solid in the Philadelphia Fed survey, industrial production rose strongly in August, existing home sales are rising, builder conditions are strong and housing starts rose to their highest since 2007 in August, suggesting that the housing recovery is back on track.
The Bank of England left monetary policy unchanged but was dovish, with a lot riding on which way Brexit goes.
Similarly, the Bank of Japan made no changes to monetary policy but looks to be setting itself up for an easing next month after flagging increasing concern that it may lose momentum towards achieving its 2% inflation target. Core inflation remained weak at just 0.6% year-on-year for August.
Chinese retail sales, industrial production and investment all surprisingly slowed in August. The slowdown likely reflects a combination of domestic factors flowing from the credit tightening a while back and the trade war. All of which suggests increasing pressure on China to de-escalate the trade war and to provide more policy stimulus – with another minor interest rate cut in the last week.
Australian economic events and implications
News that the Federal Budget was near balance last financial year – with help from underspending on the NDIS, stronger-than-expected employment and a higher iron ore price - while not surprising is good news in that it confirms that the starting point for this year’s budget is a bit stronger than previously projected, providing some scope for providing additional fiscal stimulus while at the same time continuing progress towards a surplus. That said, the NDIS underspend is unlikely to be sustained, employment growth is likely to slow and iron ore prices have started to fall, so taken together with some likely fiscal easing the news on the budget won’t be all smooth sailing going forward.
Continuing population growth of 1.6% over the year to the March quarter indicates that population growth is an ongoing source of demand in Australia which helps economic growth and helps guard against a conventional recession. That said, it’s per capita growth that ultimately counts and it’s been negative lately so getting per capita growth and hence productivity growth back up is critical.
What to watch over the next week?
Business conditions PMIs for September to be released on Monday in major countries will likely be the main focus in the week ahead, given that there has been some sign of a stabilisation in recent months.
US business conditions PMIs (Monday) are likely to show some improvement at the composite level, but with services up and manufacturing down slightly. In other data, expect to see continued modest growth in house prices and a slight fall in consumer confidence (Tuesday), gains in new and pending homes sales (Wednesday and Thursday) and a modest rise in underlying durable goods orders, solid personal spending and a slight lift in the core personal consumption deflator inflation to 1.8% year-on-year for August (all due Friday).
Eurozone business conditions PMIs (Monday) will be watched for continuing signs of stabilisation.
In Australia, a speech by the RBA’s Lowe on Tuesday entitled “An Economic Update” may provide clues regarding an imminent rate cut. Job vacancies data will also be released.
Outlook for investment markets
Share markets remain at risk of volatility in the months ahead given unresolved issues around trade and Iran and mixed economic data, as we are still in a seasonally weak part of the year for shares. But valuations are okay – particularly against still low bond yields, global growth indicators are expected to improve by next year and monetary and fiscal policy are becoming more supportive, all of which should support decent gains for share markets on a 6-12 month horizon.
Low yields are likely to see low returns from bonds once their yields bottom out, but government bonds remain excellent portfolio diversifiers.
Unlisted commercial property and infrastructure are likely to see reasonable returns. Although retail property is weak, lower for longer bond yields will help underpin unlisted asset valuations.
The election outcome, rate cuts, tax cuts and the removal of the 7% mortgage rate test are leading to a rise in national average capital city home prices, driven by Sydney and Melbourne. But beyond an initial bounce, home price gains are likely to be constrained through next year as lending standards remain tight, the record supply of units continues to impact and rising unemployment acts as a constraint.
Cash and bank deposits are likely to provide poor returns as the RBA cuts the official cash rate to 0.5% by early next year.
The A$ is likely to fall further to around US$0.65 as the RBA cuts rates further. Excessive A$ short positions, still high iron ore prices and Fed easing will provide some support though with occasional bounces and will likely prevent an A$ crash.
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