Investment markets and key developments over the past week
Share markets were a bit messy over the last week as instability in the Trump Administration and worries about US trade barriers, particularly in relation to China, continued. US shares fell 1.2%, Eurozone shares were flat, Japanese shares rose 1% and Chinese shares fell 1.3%. Australian shares lost 0.2% not helped by the soft US lead but with the start of the Banking Royal Commission and the Labor Party’s policy to cut back access to franking credits also weighing. Bond yields fell, as did metal prices but oil and iron ore prices rose slightly. The A$ fell to near US$0.77, its lowest this year.
The events over the last week highlight that there is more to go on tariffs from President Trump. Ongoing personnel changes in his team - particularly Rex Tillerson leaving, CIA director Mike Pompeo replacing him and Larry Kudlow replacing Gary Cohn - on balance suggest less opposition to further moves on tariffs notably against China. While it would be wrong to read too much into the Democratic win in the special election in Pennsylvania (as the candidate was a very lite Democrat) it’s consistent with a Democratic ‘wave’ forming to retake control of the House in the mid-terms, all of which puts more pressure on Trump to appeal to his base (and they like tariffs!). In addition, the Administration is continuing to work on a package of tariffs and investment restrictions regarding China’s alleged theft of US intellectual property. We remain of the view that there won’t be a global trade war and Trump will use his ‘Art of the Deal’ / ‘Go in Hard’ approach to try and reach a settlement with China, to which the Chinese are likely to be responsive to some degree as they know there is an issue. But it’s clear that trade will be a source of volatility and a risk to watch for some time to come.
On the positive side in the US though, the Senate passed a bill to reduce the impact of the Dodd-Frank financial regulations on smaller banks. It’s yet to go through the House but it’s likely that it or something similar will.
Should we worry about the blow-out in US short term money market rates? During the global financial crisis, stress in money and credit markets showed up in a blow-out in the spread between interbank lending rates (as measured by 3-month LIBOR rates) and the expected Fed Funds rate (as measured by the Overnight Indexed Swap or OIS rate), as banks grew reluctant to lend to each other. This ultimately drove a credit crunch and a big increase in bank funding costs (and of course “out of cycle” mortgage rate increases in Australia). Since late last year, we have been seeing a rise in the same spread, with the gap between 3-month LIBOR and the expected Fed Funds rate rising from 10 basis points in November to around 46 basis points now. This in turn has also caused an increase in money market borrowing costs in Australia. So far, the rise in the US LIBOR/OIS spread is trivial compared to what happened at the time of the GFC and unlike back then it does not reflect banking and credit stresses. Rather the drivers have been increased US Treasury borrowing following the lifting of the debt ceiling early this year, US companies repatriating funds to the US in response to tax reform and money market participants trying to protect against a faster Fed. So don’t worry – it’s not a GFC re-run! However, the longer it lasts the more it will affect bank funding costs, which could result in some (albeit minor) upward pressure on variable mortgage rates (maybe for investors?), partially offsetting recent cuts in some fixed mortgage rates.
In Australia, taxation is clearly shaping up as a major policy difference ahead of the next Federal election, with Labor adding the removal of access to franking credits for Australians who pay little or no tax to already announced policies to raise the top marginal tax rate, restrict access to negative gearing and halve the capital gains tax discount. For what it’s worth, the proposed change on franking credits does make some sense as dividend imputation was meant to remove the double taxation of dividends, not compensate people for tax already paid when they are not paying any tax on dividend income anyway. But it will affect a lot of selffunded retirees who have come to rely on franking credits (particularly less well-off retirees because they won’t have tax to offset it against). The tax changes if introduced will also drive significant impacts on various asset classes, with lots of cross currents: the increase in top marginal tax rates will likely drive greater use of negative gearing across all assets; but the changes to negative gearing will benefit new housing and other assets but would be very negative for existing housing; and the changes to dividend imputation would be negative for high dividend-yielding highly franked shares but positive for other shares and other assets including housing as those affected re-allocate their investments. That said, Labor still has to get elected, and the next election could be a year or more away.
Major global economic events and implications
While US retail sales disappointed again in February, the tax cuts, strong jobs growth and high consumer confidence point to a bounce in March. Housing starts also fell more than expected, due to units, but the rising trend in permits and still strong home builder conditions point up. Meanwhile, industrial production rose more than expected, job openings rose to a record high, small business confidence rose to its highest since 1983 and regional manufacturing conditions indexes remain very strong. Although, core CPI inflation remained at 1.8% year-on-year in February, it’s been running above a 2% pace for the last six months, and producer and import price inflation continues to move higher. All of which keeps the Fed on track to raise rates again in the week ahead. European Central Bank President Mario Draghi’s comments over the last week highlighted ongoing uncertainty about when inflation will return to target, particularly as the rise in the euro weighs on inflation. He is still clearly in no hurry to start exiting easy money. Chinese economic activity data for January and February continued to defy expectations for a slowdown. While retail sales slowed a bit, growth in investment and industrial production actually accelerated, which when combined with trade data suggests that growth may actually have picked up a bit so far this year. All of which likely emboldens President Xi Jinping in pushing on with his reform agenda, which over the last week has been facilitated by the National People’s Congress agreeing to a restructuring of the government (including a merger of bank and insurance regulators).
Australian economic events and implications
In Australia, the gap between consumer and business confidence remains, with record business conditions and just a small fall in business confidence in February and flat consumer confidence. The gap is likely to remain until wages growth picks up. Meanwhile housing finance commitments remain weak, with a fall in owner-occupier lending and a bounce in investor loans but after only after several months of falls.
What to watch over the next week?
In the US, all eyes will be on the US Federal Reserve (Wednesday), which is expected to raise the Fed Funds rate by another 0.25% taking it to a range of 1.5% to 1.75%, express increased confidence in the outlook and possibly raise the so-called “dot plot” of Fed officials’ expected interest rate increases for this year from three to four. New Fed Chair Jerome Powell may also announce that there will be a press conference after every meeting which would make it easier for the Fed to hike more frequently than every three months if needed. Our assessment remains that the Fed will hike four times (possibly five) this year and that the US money market is too dovish in just allowing for three hikes. On the data front in the US, expect a gain in existing home sales (Wednesday) and new home sales (Friday), continuing solid readings for the Markit business conditions PMIs (Thursday), a continuing rise in home prices (also Thursday) and a gain in durable goods orders (Friday).
Eurozone business conditions PMIs (Thursday) are likely to remain strong. Both the Bank of England and the Reserve Bank of New Zealand (Thursday) are expected to leave monetary policy on hold.
Japanese CPI inflation for February (Thursday) is expected to rise to 1.5% year-on-year, with core inflation also rising to 0.5% year-onyear, albeit it’s still a long way from the Bank of Japan’s 2% target.
In Australia, the minutes from the last Reserve Bank of Australia’s board meeting are likely to confirm that the central bank is comfortably on hold for now. On the data front, ABS home price data (Tuesday) is expected to be roughly flat for the December quarter, consistent with private sector data, but February labour market data (Thursday) is likely to show a solid 10,000 gain in jobs, but with unemployment remaining flat at 5.5%. Population data for the September quarter last year is likely to show continued strength, with the population continuing to rise around 1.6% year-on-year.
Outlook for markets
Volatility in share markets is likely to remain high, with investors yet to fully digest the outlook for higher inflation and interest rates in the US and as issues around President Trump and trade continue to impact. However the broad 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.
Unlisted commercial property and infrastructure are still likely to benefit from the search for yield by investors, but it is waning, and listed variants remain vulnerable to rising bond yields.
National capital city residential property price gains are expected to slow to around zero as the air continues to come out of the Sydney and Melbourne property boom and prices fall by around 5%, 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$ is likely to fall as the gap between the RBA’s cash rate and the US Fed Funds rate goes negative this month. Solid commodity prices will provide a floor for the A$ though.
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