Market Update 7 June 2019

Investment markets and key developments over the past week

Share markets, except for China’s, rose over the last week on increasing prospects for Fed rate cuts in response to the negative impact of trade wars and on hopes that US tariffs on Mexico will be averted. US shares rose 4.4%, Eurozone shares gained 2.5%, Japanese shares rose 1.4% but Chinese shares lost 2.1%. The Australian share market rose 0.7% getting a modest boost from the RBA cutting rates. The prospect of more rate cuts and easier monetary policy left bond yields flat to down. Commodity prices were mixed with oil and gold up but copper and iron ore down. The A$ rose as the US$ fell in response to the Fed moving towards rate cuts.

Mexico tariff threat dropped, but Trump’s trade wars roll on. The US has dropped plans to put tariffs on Mexico after Mexico agreed to do more to stem illegal immigration. However, the use of such tactics by the US has just added to fears that tariffs will be deployed as a weapon in relation to non-trade disputes with other countries. China’s white paper on trade wasn’t as harsh as feared but put its side of why the negotiations failed and just repeated its position on the issue. Meanwhile, the threat of the trade conflict spreading to other areas continued: beyond rare earths and company blacklists to maybe even tourism and Trump using tariffs against countries that have devalued their currencies. Meanwhile, the US is imposing tariffs on India after ending its preferential trade status and President Trump was even reportedly thinking of slapping tariffs on Australian aluminium imports (which surprise, surprise had risen as US tariffs went up on other countries!). We remain of the view that ultimately it will be in Trump’s interest to negotiate solutions to the trade disputes but this may first require economic data and share markets to weaken further to the point that he worries that it will negatively impact his re-election prospects such that he is then forced to negotiate. Of course Trump may be thinking that it’s best to let the pain ramp up a bit to the point that the Fed eases several times and the Chinese give in to his demands at which point he can negotiate a deal, share markets and economic data rebound in response and he is re-elected as a hero next year. The risk for him is that China works out that he is thinking this and so digs in waiting for the trade war to weaken the US economy so Trump won’t get re-elected next year, and they can try their luck with a more conventional president.

Fed rate cuts now looking likely – expect two this year. With the threat to growth from Trump’s trade wars rising, some US growth indicators weakening including soft jobs growth in May, the inverting yield curve suggesting a rising risk of recession and inflation remaining below target we now anticipate two rate cuts from the Fed this year. Fed officials including Chairman Powell look to be moving in this direction and a likely shift to the Fed targeting 2% inflation on average (implying a period of catchup on the high side after periods of sub-target inflation) will likely be a further push towards lower rates. The Fed is not quite there yet but unless there is a quick resolution to the trade wars, we expect it to start cutting in the months ahead.

RBA cuts for the 13th time since 2011 to a new record low of 1.25% with more to come. Our forecast remains for another cut in July or August and the cash rate to fall to 0.5% by mid next year with an increasing risk that the RBA will have to employ quantitative easing or maybe even ‘helicopter money’ beyond that point: March quarter GDP growth remained weak with annual growth at its weakest since the GFC; growth is likely to remain below 2% this year as housing construction falls further and consumer spending remains constrained as does non-mining investment; Trump’s trade wars threaten global growth and hence export demand; taken together this points to rising unemployment and ongoing significant spare capacity in the Australian economy; all of which will keep wages growth soft and inflation below target. So, to achieve its aim of lowering unemployment and boosting inflation the RBA likely has more work to do. Governor Lowe looks to be on board with the need for more interest rate cuts, maybe not to as low as 0.5% but I think he will come around to that view as growth proves softer than the RBA is expecting driving more downwards revisions to their growth and inflation forecasts.

The RBA is cutting – so why has the A$ not fallen? Put simply it was already anticipated by the fall in the A$ from US$0.80 early last year to its recent lows, this was reflected in large short positions in the A$, the iron ore price still remains supportive of the A$ and in the meantime investors have moved to price in 3 to 4 rate cuts from the Fed over the next year. That said, we still see the trend in the A$ as down to around US$0.65 by year end as Australian growth is weaker than US growth, spare capacity is much higher in Australia (eg labour market underutilisation of 13.7% in Australia versus 7.1% in the US) which will keep inflation lower in Australia than the US and we see the RBA cutting more than the Fed. However, barring a global collapse, the weakness in the A$ is likely to take it to US$0.65 as opposed to down to say the 2001 low of US$0.48.

Renewed global monetary easing continued elsewhere with the ECB remaining dovish (albeit not as dovish as markets were hoping) and the Reserve Bank of India cutting rates again. Looks like bond yields are to remain lower for even longer.

Major global economic events and implications

US data was a mixed bag with soft payroll employment growth and a weaker manufacturing conditions ISM index but stronger a non-manufacturing ISM, reasonable construction activity and still low unemployment and jobless claims. The May jobs report was soft with a much weaker than expected 75,000 increase in payrolls. Rogue weak monthly jobs numbers are not unusual but three-month average jobs growth also slowed to +151,000 and trade uncertainty is likely weighing on unemployment. While the jobs market remains tight with unemployment flat at 3.6% (as household survey employment was stronger and participation was flat) and the total of unemployment and underemployment fell further to 7.1%, wages growth slowed on an annual basis to 3.1% year on year. Slowing jobs growth and still soft wages growth add to the case for Fed rate cuts although it may wait till the July meeting - to see if there is progress in resolving trade issues and to look at June jobs data - before moving.

Conflict between the European Commission and Italy over the latter’s budget deficit blow out is back in the headlines with Commission starting the process towards an Excessive Deficit Procedure against Italy. This could ultimately result in a fine for Italy and the main pressure on Italy will come from not being able to get access to cheaper emergency funding if needed. However, it will have a long way to play out and may ultimately end in some sort of compromise.

Meanwhile the ECB announced generous terms for its next round of cheap bank financing. There was a further fall in unemployment to 7.6% in April and a rise in German factory orders, but core inflation fell back to just 0.8%yoy in May.

Australian economic events and implications

Australian data was soft with March quarter GDP growth remaining weak with private sector spending in the economy falling for the second quarter in a row. Annual growth has now slowed to 1.8% year on year, its weakest since the GFC. While strong public spending, improving investment and strong net exports should help keep growth positive it’s likely to be constrained as the housing construction downturn continues and consumer spending remains under pressure. In terms of the latter, retail sales fell again in April and car sales remained weak in May. On top of this, ANZ job ads continued to trend down in May pointing to slowing jobs growth and April housing finance (while dated by the election result) remained weak.

The news wasn’t all negative. Flowing from a continuing large trade surplus, Australia’s current account deficit has fallen to its lowest since the 1970s (meaning less reliance on foreign capital inflow) and the pace of decline in home prices slowed further in May according to CoreLogic. Our view remains that the combination of the confidence boost from the election, rate cuts, a relaxed mortgage servicability test and help for first home buyers will help home prices bottom by year end but a quick return to boom time conditions is unlikely given still very high house prices and debt levels, continuing tight lending standards and a rising trend in unemployment. Meanwhile the housing construction cycle has only just started to turn down and lags the house price cycle and so still has a long way to fall.

What to watch over the next week?

In the US, apart from the noise around tariffs, the focus is likely to be on inflation and retail sales. Inflation data (Wednesday) is expected to show core CPI inflation unchanged at 2.1% year on year and retail sales (Friday) is expected to show solid growth of around 0.6% month on month. In other data releases expect job openings and hiring (Monday) to have remained strong, small business confidence (Tuesday) to dip slightly and industrial production (Friday) to rise.

Chinese data for May will help shed light on how the economy is holding up as the trade war returned. Expect to see falls in both exports and imports (Monday), stable but subdued growth in industrial production (+5.4%yoy) and investment (+6.1%yoy) and a rebound in retail sales growth to 8.1%yoy (all Friday) and continuing strength in credit growth. Consumer price inflation (Tuesday) is expected to rise to 2.7% year on year but underlying inflation is likely to remain soft.

In Australia the focus will be on confidence and jobs. Expect a bit of a post-election bounce in the NAB’s business survey (Tuesday), little change in consumer confidence (Wednesday) and a 20,000 gain in employment for May (Thursday) helped by electoral workers which is likely to have pushed unemployment temporarily back down to 5.1%.

Outlook for investment markets

Share markets are likely to see further volatility and weakness in the short term on the back of uncertainty about trade and mixed economic data. But valuations are okay, global growth is expected to improve into the second half if the trade issue is resolved and monetary and fiscal policy have become more supportive of markets and will likely become even more so, all of which should support decent gains for share markets through 2019 as a whole.

Low yields are likely to see low returns from bonds, but government bonds remain excellent portfolio diversifiers.

Unlisted commercial property and infrastructure are likely to see a further slowing in returns. This is particularly the case for Australian retail property. However, lower for even longer bond yields will help underpin unlisted asset valuations.

National average capital city house prices are likely to remain under pressure from tight credit, record supply and reduced foreign demand. However, the combination of imminent rate cuts, support for first home buyers via the First Home Loan Deposit Scheme, the relaxation of the 7% mortgage rate serviceability test and the removal of the threat to negative gearing and the capital gains tax discount point to house prices bottoming out by year end and higher than we had been expecting. We see a 12% top to bottom fall in national capital city average prices. Next year is likely to see broadly flat prices as rising unemployment acts as a bit of a constraint.

Cash and bank deposits are likely to provide poor returns as the RBA cuts the official cash rate to 1% by year end.

The A$ is likely to fall further to around US$0.65 this year as the gap between the RBA’s cash rate and the US Fed Funds rate will likely push further into negative territory as the RBA moves to cut rates by more than the Fed does. Excessive A$ short positions and high commodity prices may help drive a short-term bounce though before the downtrend resumes and will likely prevent an A$ crash.