Investment markets and key developments over the past week
It was back to “risk-off” over the last week as the resumption of the US/China trade war, a less dovish than expected Fed and mixed economic data pushed global share markets down. US shares fell 3.1% for the week, Eurozone shares lost 3.9%, Japanese shares fell 2.6% and Chinese shares lost 2.9%. The Australian S&P/ASX 200 index followed the All Ords index to a new record high early in the week but the local market succumbed to global share market falls later in the week. Australia is not directly affected by the US/China trade war, but it will be impacted to the extent that weaker growth in the US and, particularly, China will affect demand for our exports and business confidence. As a result, resources shares were particularly hard hit but gains in relatively defensive sectors like telcos, health and real estate limited the falls in the Australian share market compared to global markets. Over the week it only fell by 0.4%. Bond yields plunged on the news of the resumption of the trade war with the Australian 10-year bond yield falling to a new record low of 1.08%. While the gold price rose on safe-haven demand, oil, metal and iron ore prices all fell with the latter impacted by Vale’s gradual return to production. The trade war also weighed on the A$ which fell just below US$0.68 with the US$ rising over the week.
Trade war truce over for the third time as President Trump puts a 10% tariff on the remaining $300bn of imports from China from September 1 with a threat it could go well beyond 25%. This is what he had threatened to do after the last round of trade talks collapsed in May before it was put on hold pending more talks. The latest talks made little progress, so the trade war is back on again. The timing of the move may also reflect a desire by Mr. Trump to force the Fed to ease more and to show that he is tougher on trade than far-left Democrat presidential candidates Sanders and Warren. Assuming it goes ahead on September 1, this latest round of tariffs will hit consumer goods which were avoided in prior rounds and put more downward pressure on business confidence and investment plans as it imperils supply chains. Rough estimates suggest this could knock around 0.25% from US growth and around 0.3% off Chinese growth (once retaliation is allowed for) – all of which will maintain pressure on central banks to ease further. While President Trump is relaxed at present – because the US economy is still strong – the threat to the economy from escalating tariffs risks threatening his re-election next year as recessions and rising unemployment have historically killed the re-election of sitting presidents (Hoover, Ford, Carter and Bush senior) and for this reason we remain of the view that a deal will ultimately be reached. But it could still get worse before it gets better, and the risks have gone up as China may be waiting till after the election. At the same time, it doesn’t help that the trade spat between Japan and South Korea looks to be escalating.
Fed eases by 0.25%, Powell confuses – but they will cut by more. While Fed Chair Powell confused the Fed’s message after it cut rates – by saying it’s a “mid-cycle adjustment” and “not the beginning of a long series of cuts” but it may not be “just one” – the Fed’s post-meeting statement left the door open to further cuts and it has ended its Quantitative Tightening program (of gradually taking the cash out of the economy that it pumped in under QE) much earlier than expected. The Fed rarely cuts just once, past “mid-cycle adjustments” saw several easings and the risks to growth notably around trade won’t go away quickly so we see another one or two more cuts with the next in September. The on-again escalation in the trade war could force them to do more.
After their strong gains so far this year share markets are at risk of a short-term correction – with the escalating US/China trade war, along with Middle East tensions and mixed economic data providing possible triggers as we enter a seasonally weak part of the year for shares. Since 1985, August and September have been the weakest months of the year for US shares and September, October and November have been weak in Australia too – see the next chart. But valuations are okay – particularly against low bond yields, global growth indicators are expected to improve, 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.
Stagnation in real Australian incomes since 2009 but relatively stable income inequality. The latest Household Income and Labour Dynamics (HILDA) survey of Australian households showed continuing stagnation in real median incomes since 2009. The reasons likely reflect some combination of low wages growth, high unemployment, and underemployment, income taxes growing faster than incomes and also payback for the rapid growth seen last decade that was helped by the resources boom at the time. In a way, it’s a bit like the Australian share market – that boomed last decade but has now only just got back to its 2007 high. Returning to decent growth in incomes is a key challenge for policymakers as ongoing stagnation risks rising community angst and support for populist, self-defeating economic policies. It's consistent with the RBA’s desire to boost growth and get unemployment below 4.5%. Fortunately, income inequality has been pretty stable over the period since the HILDA survey started in 2001.
Major global economic events and implications
US economic news was mixed over the last week with a strong consumer-related data, weak business data and solid but slowing jobs growth. Consumer income and spending rose solidly in June, consumer confidence for July rebounded to near all-time highs and pending home sales saw a good rise. Against this though, the ISM manufacturing conditions index fell further in July tracking the Markit PMI down on the back of the trade war’s escalation and construction spending fell in June for the second month in a row. Meanwhile, payroll growth in July was solid at 164,000 and unemployment remains low at 3.7%, but downward revisions to prior months have seen 3 months average employment gains slow to 141,000 and wages growth remains soft at 3.2% year-on-year based on average hourly earnings growth of just 2.8% year-on-year according to the employment cost index. Slowing jobs growth, still soft wages growth and core private consumption deflator inflation running at 1.6% yoy supports the Fed’s decision to ease and leaves them on track to cut again in September.
Nearly 80% of US S&P 500 companies have reported June quarter results and they remain reasonably good with 77% beating on earnings, 59% beating on sales and earnings growth for the quarter looking like it will come in at around +3% yoy, which is up from expectations for a small fall at the start of the reporting season.
Eurozone economic data was soft with June quarter GDP growth of just 0.2% quarter-on-quarter or 1.1% year-on-year, a further fall in economic confidence in July and core inflation falling back to just 0.9% yoy all of which is consistent with more ECB easing next month.
The Bank of Japan made no changes to its ultra-easy monetary policy but added that it will not hesitate to do more if momentum towards its inflation target is threatened. Meanwhile, jobs data was strong (which is easy with a falling labour force) but industrial production was weak.
China’s composite business conditions PMI was little changed in July suggesting stable growth.
Australian economic events and implications
Australia June quarter inflation data provided a rare upside surprise – but it was only marginal and doesn’t change our view on the RBA. Headline inflation rose thanks to higher petrol, tobacco and health costs but only to 1.6% year-on-year and underlying inflation fell to a record low of 1.4% year-on-year with plenty of evidence of ongoing pricing weakness across the economy thanks to spare capacity, competition, technological innovation, and weak demand. The release wasn’t weak enough to bring on another rate cut next week and we remain of the view that policy stimulus seen so far will help but won’t be enough to push unemployment below 4.5% as the RBA would like and so further monetary easing is likely with a cut to 0.75% in November and a cut to 0.5% in February next year likely. The escalating US/China trade war will only add to pressure on the RBA. And a slide in annualised wage growth in new Enterprise Bargaining Agreements adds to the weak inflationary pressures in the economy.
Australian data releases were mixed with building approvals falling, credit growth continuing to slow and retail sales coming in very weak again in the June quarter but the terms of trade rising again in the quarter on the surge in the iron ore price which will boost national income and capital city dwelling prices rising for the first month in July since September 2017. While the election, rate cuts and positive headlines around APRA’s relaxation of the interest rate serviceability test and tax cuts are continuing to boost home buyer demand - as evident in improved auction clearance rates and this has seen house prices stabilise - gains going forward are likely to be constrained to the low single digits reflecting tight credit conditions, record unit supply and an upwards drift in unemployment.
What to watch over the next week?
In the US expect the non-manufacturing conditions ISM for July (Monday) to soften slightly and data for job openings (Tuesday) and producer prices (Friday) will also be released. The US June quarter earnings reporting season will continue.
Japanese June quarter GDP (Friday) is expected to show weak growth of just 0.2% quarter on quarter or 0.7% year on year.
Chinese export and import growth (Thursday) is expected to remain negative and underlying inflation (Friday) is expected o remain weak.
In Australia, the RBA (Tuesday) is expected to leave rates on hold at 1% but retain an easing bias. Basically, the RBA is waiting to see the impact of its June and July rate cuts and the Federal Government’s tax cuts for low- and middle-income earners and in particular it wants to see lower unemployment. However, its Statement on Monetary Policy (Friday) is likely to modestly downgrade its inflation and growth forecasts again and the RBA is likely to maintain guidance that rate hikes are a long way off and it stands ready to ease again if needed. This is also likely to be part of the message delivered by Governor Lowe in his Parliamentary testimony on Friday. We doubt that the policy easing seen so far will be enough to get unemployment below 4.5% and wages growth and inflation up to target and so expect the RBA to resume cutting later this year with 0.25% cuts in November and February. On the data front, expect the June trade surplus (Tuesday) to have remained around a record, housing finance (Wednesday) to remain soft and ANZ job ads will also be released.
Australian June half earnings reports will ramp up with about 13 major companies reporting including CBA, Suncorp and Transurban (Wednesday) and AMP, IAG, AGL and Newscorp (Thursday). Consensus expectations are for around 2% earnings growth for 2018-19 but this is mainly due to resources.
Outlook for investment markets
Share markets are at risk of short-term volatility and weakness on the back of the escalating US/China trade war, Middle East tensions and mixed economic data as we enter a seasonally weak part of the year for shares. But valuations are okay – particularly against low bond yields, global growth indicators are expected to improve and monetary and fiscal policy are becoming more supportive all of which should support decent gains for share markets over the next 6-12 months.
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 combination of the removal of uncertainty around negative gearing and the capital gains tax discount, rate cuts, support for first home buyers via the First Home Loan Deposit Scheme and the removal of the 7% mortgage rate test suggests national average capital city house prices have probably bottomed. Next year is likely to see broadly flat prices though as lending standards remain tight, the 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$0.65 this year as the RBA cuts rates further. Excessive A$ short positions, high iron ore prices, and Fed easing will help provide some support though with occasional bounces and will likely prevent an A$ crash.
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