Market Update 20 Cctober 2017

Investment markets and key developments over the past week

Share markets mostly rose over the last week helped along by continuing good economic data. US shares gained 0.9% boosted by progress towards tax reform, Japanese shares rose 1.4%, Chinese shares rose 0.2% and Australian shares gained 1.6%. Eurozone shares were flat though with Spanish shares slipping as the Spanish Government looks to be moving towards taking over the Government of Catalan. Australian shares are continuing to play catch up after underperforming significantly year-to-date with utilities, financials, consumer staples, IT, resources and health stocks all seeing good gains over the last week. Bond yields rose in the US and Europe but fell in the UK and Australia. Oil and metal prices rose but the iron ore price was flat. The A$ fell as the US$ rose on the back of progress towards US tax reform.

Given the 30th anniversary of the 1987 share market crash, this note provides a comparison to today: the prior 12 month gains have been far more modest today and valuations are now far more reasonable once lower inflation and bond yields are taken into account. All of which suggests the circumstances are very different now. The 1987 crash was also a bit of an oddity because it was unrelated to any economic downturn at the time or afterwards. While it may have been triggered by rising inflation and tightening monetary conditions in the US its severity owed much to “portfolio insurance”, which saw declines trigger more selling and further declines. While circuit breakers introduced after the 1987 crash are designed to limit major falls, the growth of high frequency trading, ETFs and possibly investment programs driven by artificial intelligence all mean that we can’t rule out another crash like 1987 at some point. At the end of the day though we also have to bear in mind that crashes and bear markets are part and parcel of share investing and ultimately the price we pay for higher long-term returns from the asset class compared to say bank deposits.

Chinese President Xi Jinping’s opening address at the Communist Party Congress referred to “a new era of socialism with Chinese characteristics”. However, it sounded more likely a continuation of the recent direction in policy rather than a big shift in direction. There was more focus on quality growth, less on growth for growth’s sake, ongoing reform and more emphasis on pollution and equality (both global themes). While there may be less emphasis on growth targets the objective to double 2010 GDP by 2020 implies annual GDP growth in the range of 6-6.5%. Thus we expect growth to remain solid, albeit we may see a bit of fine tuning towards more economic reform.

Progress continues towards tax reform in the US with the Senate passing a 2018 budget, with the House likely to vote on the budget and probably pass it too in the next week or so. The passage of a 2018 budget is a critical step because it allows tax reform to proceed under the so-called budget “reconciliation” process which means Republicans would only require 51 votes to pass it through the Senate rather than requiring Democrat support to get to 60 votes. Congressional tax-writing committees are planning to release draft tax reform legislation by early November, with the aim of enacting tax reform by year-end (or it could be early next year). The main risks relate to the Republicans making sure they lose no more than two senators in terms of support for tax reform (as it would still pass with Vice President Pence’s vote). An Alabama Senate special election presents some risk on this front as polls currently show the GOP and Democrat candidates tied (in Alabama of all places! – not so good for Trump). We remain of the view that tax reform or tax cuts will get up (with a 60% or so probability). The poor performance of high tax-paying companies suggest that tax reform is not priced into US shares.

While the first round of NAFTA talks have ended with no agreement and Mexico and Canada appear seemingly at loggerheads with a now protectionist US, the fear that the US will just withdraw has been eased by an extension of the talks into next year. Thus it looks like the US would still prefer a deal. We note trade wars are still yet to happen under Trump. Our base case remains some sort deal will be reached.

While some have interpreted the Austrian election (where the far right Freedom Party saw support rise to around 26% and are likely to be a junior partner in a government with the centre right People’s Party) as another threat to Europe, I wouldn’t read too much into it. The centre left Social Democrats did better than expected, Austria has already taken a harder line on immigration, Austria has been here before with the Freedom Party (in 1999) and the Freedom Party dropped its anti-euro stance. So yes Austria may slow European integration but there is nothing in the election outcome suggesting a new threat to the euro.

Japan’s election saw a strong result for Prime Minister Abe’s LDP-led coalition, which retained its two thirds parliamentary majority. PM Abe is likely to retain leadership of the LDP next year and may seek to change Japan’s pacifist constitution. Meanwhile, Abenomics will continue and this will be negative for the yen and positive for Japanese shares.

New Zealand has a new coalition Government with NZ First agreeing to support Labour and the Greens. The risk is that it will take a bit of a populist bent in contrast to the rationalist National Party Government it replaces, reflecting similar pressures to those seen in recent elections in the UK, US and Australia, putting downwards pressure on the NZ$.  

The Australian Government unveiled its long-awaited energy policy with a focus on both reliability and emissions reduction. This is designed as a way out of the surge in prices that has occurred in response to gas shortages, unsettled climate change policy and a surge in intermittent renewable power without storage. Although I am a bit unsure as to why it should necessarily drive lower prices, the dual focus does make sense. It still must pass Federal parliament though (with bilateral support essential if industry is to take it seriously) and needs state agreement. So there is a way to go yet.

The last Holden – a sad day, but hard to see a significant macro-economic impact. October 20 was the end of the road for mass car production in Australia, with the last Holden rolling of the line at Elizabeth in South Australia. I grew up in a Holden family and my best friend’s family had Fords. I always thought that if we want an Australian car industry we should not rely on government protection as it will just result in museum pieces, rather we should put our money where our mouth is and buy Australian cars. Which I have done - being so impressed by the style, quality and value for money of Australian made cars since the mid-1990s that I have bought four of them; first a pleasant trip to the dark side with a Ford and then three Holdens, including one of the last to be made which I got in June. However it’s clear that not enough Australians agreed, opting for foreign made SUVs instead. So it’s a rather sad day for me, and more significantly the 950-odd workers in Elizabeth and all those who worked in or around the Australian car industry (maybe around 15,000 workers in total). But putting my rational economist hat back on it would be wrong to exaggerate the negative implications of this for Australia. Car plant closures are certainly a big negative for those affected, but the industry has been shedding workers for years as automation took over and market share fell. Holden recently sent me a photo of my new car on the production line and I could see robotic arms but no people. More broadly, manufacturing employment has been in steady decline since the 1960s (when it was around 25% of the workforce) to now be below 10%. Growth in services jobs have and will continue to make up for the loss. The decline of say 15,000 auto industry jobs also compares to 20,000 new jobs in Australia in September and 372,000 over the last year.  It’s still a sad day though!

Major global economic events and implications

US data remains solid. While housing starts and permits remained depressed by the hurricanes in September, a bounce back in the home builders’ conditions index points to a rebound this month. Add to this the lowest level in jobless claims since 1973 and strong regional manufacturing conditions index readings for October, which points to strong underlying economic growth. With Fed Chair Yellen expressing ongoing confidence that inflation will rise, the Fed remains on track for another hike in December (with the money market seeing an 84% probability) and likely another three hikes next year, whether it’s Powell or Taylor or whoever else is appointed to be next Fed Chair. Meanwhile, although consensus profit growth expectations for September quarter earnings growth are relatively subdued at +4.3% year-on-year (weighed down by insurers after the hurricanes), results to date have been solid with 82% of results beating on earnings and 75% beating on sales. That said, only 88 S&P 500 companies have reported so far.

Chinese economic activity data for September provided no surprises with a fractional slowing in GDP growth to 6.8% year-on-year, slight lifts in growth in retail sales and industrial production but a slight fall in investment growth. It basically tells us that Chinese growth has stabilised at a solid rate. Monetary policy will not be eased much going forward but nor will it be tightened. Rather it remains a case of continued fine-tuning with maybe a bit more post-Congress emphasis on reform, bringing credit growth under control and more property cooling measures but only to the extent growth remains solid.

Australian economic events and implications

Australian jobs data surprised on the upside yet again in September with annual jobs growth of 3.1% at its highest since 2008 and unemployment continuing to trend down. Our jobs leading indicator remains strong, pointing to continued solid jobs growth. This is all good news and should lead to faster wages growth eventually – but the US experience (with still low wages growth despite 4.2% unemployment) along with ongoing high levels of job insecurity suggest we may have a way to go yet. So while the strong jobs data taken in isolation points to the risk of an earlier than expected RBA rate hike, the ongoing weakness in wages growth along with risks around the consumer and the still high A$ argue against a near-term rate hike. On this front the latest RBA minutes add little that is new, however it did reiterate that the there is no mechanical link between higher interest rates overseas and Australian interest rates, with domestic economic conditions being the key driver of local interest rates. Out of interest: looked at Tasmania lately? – its unemployment rate has fallen below that of Queensland!

What to watch over the next week?

In the US, expect October Markit business conditions readings (Tuesday) to remain solid at around the 53-55 range, the trend in durable goods orders to remain up and further gains in home prices (both Wednesday), however hurricanes may have continued to dampen new home sales (also Wednesday) and pending home sales (Thursday). Similarly, the hurricanes are likely to have resulted in September quarter GDP growth (Friday) slipping slightly to 2.5% annualised from 3.1% in the June quarter, but a bounce back is likely in the current quarter. September quarter earnings results will continue to flow.

In the Eurozone, the focus is likely to be on the ECB which is likely to announce that quantitative easing (QE) will be continued for another 9 months from January 2018 at the reduced rate of €30 billion a month with a reaffirmation of forward guidance that rates won’t be raised until “well past” the ending of QE. Perhaps the main interest though will be on whether the ECB indicates that this will likely be it for QE, or whether the door will be left open for another extension if needed. On the data front, expect October business conditions PMIs (Tuesday) to remain strong at around 56-58, pointing to continuing solid economic growth.

In Japan, expect the October manufacturing conditions PMI to move up to around 53.5 but core inflation (Friday) for September to remain low at around 0.2% year-on-year.

In China the focus will be outcomes from the Communist Party Congress, but it’s doubtful that it will signal anything unexpected. Property price data will be released Monday and industrial profit data on Friday.

In Australia, expect higher energy prices only partly offset by lower petrol prices to push CPI inflation (Wednesday) up to 0.8% in the September quarter or 2% year-on-year. However, underlying inflation is likely to have remained soft at 0.5% quarter-on-quarter thanks to ongoing pricing softness in response to constrained demand, weak wages growth and the rise in the value of the A$. This should still take underlying inflation back to 2% year-on-year though, which is at the bottom of the RBA’s target range (after 1.8% year-on-year in the June quarter). Data for skilled vacancies and producer prices will also be released.

Outlook for markets

While we are moving into a more favourable part of the year for shares from a seasonal perspective, North Korean risks remain high, Trump-related risks remain and Wall Street is overdue for a decent 5% or so correction which would affect other share markets. However, beyond short term uncertainties we remain in a sweet spot in the investment cycle – with okay valuations particularly outside of the US, solid global growth and improving profits but still benign monetary conditions – so we remain of the view that the broad trend in share markets will remain up. This has already helped drag Australian shares up out of their June to September range-bound malaise.

Low starting point bond yields and a likely rising trend in yields will likely drive poor returns from bonds.

Unlisted commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this will wane eventually as bond yields trend higher.

Residential property price growth in Sydney and Melbourne looks to have peaked with a slowdown likely over the next year or two, but Perth and Darwin are likely close to the bottom, Hobart is likely to remain strong and moderate price gains are expected to continue in Adelaide and Brisbane.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.25%.

While further short-term upside in the A$ is possible, our view remains that the downtrend from 2011 will ultimately resume as the Fed continues to tighten and the RBA remains on hold into next year.