Investment markets and key developments over the past week
Share markets continued to rise over the last week helped by good news regarding US/China trade talks. US shares rose 0.6%, Eurozone shares gained 0.8%, Japanese shares rose 2.5% and Chinese shares rose 5.4%. Australian shares rose 1.7% helped by reasonable earnings results, more talk of rate cuts and upgrades to earnings growth expectations for resources stocks on the back of higher commodity prices. Bond yields were flat to down a little bit. Oil, gold and metal prices rose but iron ore prices fell back a bit but remain very high. The $A fell slightly despite a lower $US as rate cut talk continued.
Momentum is continuing to build towards a resolution of the US/China trade dispute. There is more to go, but President Trump has extended the March 1 deadline to further raise tariffs on Chinese imports as a result of “substantial progress” in trade talks with China. If there is further progress President’s Trump and Xi plan to meet conclude the agreement. Our view remains that a deal is likely as it’s in both sides interests after the mayhem in business confidence and share markets last year’s trade war flare up contributed to. Trump knows this and wants to make sure that an escalating trade war does not threaten his 2020 re-election prospects by pushing up unemployment.
Business conditions PMIs were mixed in February – up in the US and Eurozone driven by services but with manufacturing conditions falling in the US, Eurozone and Japan. And Australia was weak. We still see the current environment as like in 2011-12 and 2015-16 – both of which saw shares fall 20% or so as PMIs fell only to then see a rebound. But at this stage we are still waiting for a clear rebound in PMIs which is leaving shares vulnerable to a pullback in the short term, although we expect policy stimulus to underpin stronger PMIs (and shares) into the second half of the year.
Meanwhile the Brexit comedy continues with MPs now defecting from Labour and the Conservatives. Brexit was sold on a lie by the Brexiteers - that the UK could have its cake (free trade with the EU) and eat it too (without the EU’s rules and restrictions). Of course, this was never on as far as the EU was concerned, but it got the yes vote over the line. So, the referendum has left a mess to try and sort out (for a parliament that doesn’t have majority support for Brexit). The best way out of this mess would be to have another referendum as the British people would now have a better understanding of the facts. Anyway, this all has a way to go which is not great for the UK economy – but just remember that for the rest of us this is just a sideshow second order issue!
It’s hard to get too excited at this stage by reports of Chinese restrictions on imports of Australian coal. 25% of Australian coal exports go to China and if there is a ban on all of this it could knock up to 0.7% off Australian GDP. This is very unlikely though as so far it looks like slower processing as opposed to a complete ban, it would violate the free trade agreement between Australia and China and in any case Australian coal exports can be diverted to other markets as China still needs the coal. It will be a bigger issue though if it signals deeper problems in Australia’s relationship with China.
Major global economic events and implications
US data was mixed over the last week. Underlying capital goods orders, the Leading Index and manufacturing conditions in the Philadelphia region were all soft but jobless claims fell, home builder conditions rose and the composite PMI for February rose (with manufacturing down but services up). All of which is consistent with the Fed staying on hold.
Meanwhile, the minutes from the Fed’s January meeting confirm its dovish shift on rates – with it seeing few risks to pausing rates and unclear as to whether it will raise rates later this year or leave them on hold - and in relation to quantitative tightening with the Fed heading towards ending its balance sheet reduction by year end. In terms of the latter expect some sort of formal announcement at the March meeting with a likely slowing (or taper) in the rate of QT and its end by the end of the year which will leave the Fed’s balance sheet far higher than previously expected. Of course, whatever it does will be contingent on economic conditions.
Is the Fed heading towards easier monetary policy for even longer? This year the Fed is undertaking a review of its approach with some Fed officials extolling the benefits of “average inflation targeting” which would currently accept an overshoot of the 2% inflation target to make up for all the years that inflation has been below target. The Fed goes in circles on this issue and it’s arguably what should be implied by the Fed’s current reference to the inflation target being “symmetric”. But if “average inflation targeting” is adopted then it could imply that the current pause on rates goes for longer than otherwise (which would be good for risk assets like shares and negative for the $US) but then bond yields would eventually go higher than otherwise (which would eventually be bad for risk assets and positive for the $US as the Fed has to tighten by more down the track).
The US December quarter earnings reporting season is now 90% done and remains much better than feared. 72% beat on earnings with an average beat of 3.2% and 59% beat on sales. Earnings growth is running at 18.5% year on year for the quarter. But as can be seen in the next chart the level of surprises and earnings growth is down. US earnings growth is likely to be around 5% this year as the boost from the corporate tax cut drops out.
At last some good news out of the Eurozone with the composite business conditions PMI for February up 0.4pts after falling through much of the last year. Manufacturing conditions fell further but this was offset by the more important services sector. In Germany the IFO business conditions survey for February continued to fall. Pressure remains on the ECB to provide more cheap bank financing – which looks likely to be announced next month.
The news out of Japan wasn’t so good though with a sharp fall in the manufacturing conditions PMI for February and soft data for machine orders, machine tool orders, exports and imports. Core inflation in February remained weak at 0.4% year on year.
Australian economic events and implications
Australian data was a mixed bag with another strong jobs report, but wages growth still stuck at a low 2.3% year on year (or 2% were it not for the faster increase in the minimum wage) and a further decline in the CBA’s business conditions PMIs for February with very weak service sector conditions. There is no doubt that jobs growth has been and remains strong. But our assessment remains that it will slow going forward in response to reduced housing construction and soft consumer spending on the back of falling house prices resulting in an increase in unemployment and lower for longer inflation ultimatley providing the trigger for rate cuts later this year, starting in August (but they could come earlier).
Speaking of rate cuts, RBA Governor Lowe’s parliamentary testimony and the minutes from the RBA’s last meeting didn’t provide a lot that was new – really just confirming the shift to a neutral bias on interest rates. But the minutes did further elevate the importance of house prices in relation to the RBA’s thinking on rates with the observation that if house prices were to fall “much further” it would likely drive a downwards revision to its growth and inflation forecasts and an upwards revision to its unemployment forecasts. So while the RBA has not been too fussed with the house price falls to date, it's signalling that it will get a lot more concerned (read rate cuts) if (as we expect) house prices continue to fall.
The Australian December half earnings reporting season has been better than feared but shows a slowdown in underlying growth, caution regarding the domestic outlook but an overall upgrade in earnings growth expectations thanks to resources stocks. 75% of companies have now reported. 56% of companies have seen their share price outperform on the day of reporting (which is above a longer term norm of 54%) but against this only 40% have surprised analyst expectations on the upside which is below the long run average of 44%, 34% have surprised on the downside which is above the long run average of 25%, the proportion of companies seeing profits up from a year ago has fallen and only 59% have raised their dividends which is a sign of reduced confidence in the outlook – six months ago it was running at 77%. Concern remains most intense around the housing downturn and consumer spending. While 2018-19 consensus earnings growth expectations for this financial year have slipped to 1% for the market excluding resources they have been upgraded to 14% for resources stocks as the higher iron ore price gets factored in. So earnings growth expecations for the market as a whole have been revised up to 5% from 4.3% a month ago. While several cashed up companies announced higher dividends ahead of Labor’s proposed franking credit cutback, overall dividend upgrades have fallen.
What to watch over the next week?
In the US, expect a bounce back in February consumer confidence, continued modest gains in home prices but a slight fall in January housing starts (all due Tuesday), December quarter GDP growth (Thursday) to show a slowdown to 2% annualised growth and the February manufacturing conditions ISM index (Friday) to slow to around 56. The core private consumption measure of inflation for December (also due Friday) is expected to remain unchanged at 1.9% year on year. Meanwhile Congressional testimony by Fed Chair Powell on Tuesday is likely to confirm that the Fed remains patiently on hold regarding interest rates and flexible regarding its quantitative tightening program.
Eurozone data is expected to show unemployment remaining unchanged at 7.9% in January and core inflation for February (both due Friday) remaining around 1.1%yoy. Economic confidence data for February is due Thursday.
Japanese industrial production data for January (Thursday) is expected rise slightly and labour market data (Friday) is expected to remain strong helped by the declining workforce.
Chinese business conditions PMIs for February (due Thursday and Friday) are expected to show continuing softness in manufacturing but solid services sector conditions.
In Australia, December quarter construction data (Wednesday) is expected to show a 0.7% gain, December quarter private investment data (Thursday) is expected to rise 0.8% with capex intentions also improving slightly, credit growth (also Thursday) is likely to have remained moderate in January and CoreLogic house price data for February (Friday) is expected to show a further decline.
The Australian December half earnings results season will conclude with 43 major companies reporting including Boral, Lendlease and QBE (Monday), Caltex (Tuesday), RIO Tinto and Seek (Wednesday), and Ramsay Health Care (Thursday).
Outlook for investment markets
Shares are likely to see volatility remain high with a high risk of a short term pull back, but valuations are okay, 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 pausing.
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, price falls feeding on themselves 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.
The $A is likely to fall into the $US0.60s as the gap between the RBA’s cash rate and the US Fed Funds rate will 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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