Market Update 15 September 2017

Investment markets and key developments over the past week

The news flow was generally positive over the past week as investors were encouraged by signs that US Republican tax reform plans were still in play, a lift in inflation across advanced economies and indications that the impact of the hurricanes in the US caused less disruptions and disaster than initially feared. Global equities mostly finished the week higher - US +0.5%, Eurozone +0.6%, Japan +1.9%, China +0.1% while Australian shares were down 0.3%.

Positive market sentiment and signs of inflation lifted global bond yields. UK bond yields surged after strong UK inflation data, prompting speculation of near-term rate hikes by the Bank of England (BoE). Commodities were mixed with oil prices higher because the International Energy Agency forecast stronger oil consumption for this year while iron ore and copper prices were hit by softer Chinese data.

Speculation about US tax reform heated up again this week with House of Representatives speaker Paul Ryan saying that an outline for tax reform would be unveiled in the week beginning September 25th and then be signed into law and functioning in early 2018. While it is positive to see that taxation reform is still on the political agenda, the concern is really around whether the Republican Party will be able to pass this new legislation given budget constraints and the mess in trying to reform Obamacare. The dates outlined by Ryan line up with the dates for when the US budget needs to be passed (the US fiscal year runs from October – September), so Congress needs to pass the FY18 budget sometime in October, which will then enable the tax reform bill to be voted on.

Our thoughts are with those affected by Hurricane Irma, which hit the Caribbean Islands and Florida. The rebuild effort in the US from Hurricane Irma and Harvey is estimated to be around $290bn about three times the size of Hurricane Katrina. The disruption to GDP growth in the third quarter is estimated to be in the region around 0.5 percentage points, but the impact is still uncertain. The disruption to growth will be reversed in the fourth quarter as rebuilding occurs so the Federal Reserve (Fed) will look through the one-off impacts to growth which means little direct implications for monetary policy.

Geopolitical risks remain high. North Korean launched another missile over Japan and the UN approved new sanctions on North Korea which included banning North Korean textile exports and a cap on fuel supplies to the region. The uncertainty created by North Korea is unsettling, but this will continue as a diplomatic solution is far from occurring yet which means further risks of declines in share markets and demand for safe havens like the Japanese Yen and gold. US President Trump continues to put more pressure on China regarding North Korea and has threated to implement secondary sanctions on Chinese banks and other companies which is negative for the trade relationship between the US and China (which is negative for global trade) but we don’t expect a full blown trade war to occur between the US and China.

Major global economic events and implications

US data was mixed. Retail sales and industrial production disappointed in August but some of the weakness reflects the impacts of Hurricane Harvey. Consumer sentiment weakened a little in September, but is still holding at a very strong level – around its highest level since 2000. The August core consumer price index was up by 1.7% over the year (see chart below), giving confidence that inflationary pressures are still apparent, after months of poor price data, which means that a Fed rate hike is still likely at the December meeting. But, the Fed’s decision is still data dependent so inflation readings over the next few months will be important. US job openings were up again in July and small business optimism is still hovering around 14 year highs.

UK August inflation data was surprisingly strong. The core consumer price index rose to 2.7% on an annual basis, the fastest pace of growth since December 2011 which could mean the start of rate hikes from the BoE. Markets are pricing in a good chance of a hike in November after a hawkish statement from the BoE meeting which was reinforced by Gertjan Vlieghe (a voting BoE member). But, wages growth is still low in the UK with average earnings up by 2.1% over the past year despite the unemployment rate being at a 43 year low of 4.3%, so the central bank will tread carefully in raising interest rates.

Chinese data for August was softer than expected but is far from low. Fixed asset investment was up by 7.8% (year to date), industrial production is 6.0% higher over the year, retail sales growth rose by 10.1% over the year and money supply growth slowed in August. Chinese GDP growth in the first half of 2017 was stronger than expected in thanks to fiscal spending which has now slowed, with higher interest rates also contributing to softer activity. Volatility in Chinese data is normal as policymakers open or close the fiscal and monetary taps to affect demand. Overall, Chinese activity is still holding up well, which is positive for other Asian economies through trade and for Australia because of the reliance on Chinese commodity imports.

Australian economic events and implications

Consumer confidence rose in September, but still remains negative. Continued poor consumer sentiment readings may have negatively impacted the business sector with business confidence taking bit of a hit in August (see chart below). But this follows months of solid rises in confidence, so a slight pullback isn’t too concerning, particularly as reported business conditions, trading and profitability are still looking strong.

Businesses are reporting solid demand for employment which was matched by stellar job numbers in August. Employment jumped by 54.2K due to a surge in full-time jobs. While the strength in the labour market is very positive for household budgets and sentiment, the outlook for Australia is still mixed because overall price growth is soft. While price growth remains low we don’t think that the Reserve Bank of Australia (RBA) needs to be raising interest rates. Wages growth is also still too weak which means that the consumer sector will have trouble absorbing any interest rate hike (because it will increase interest payments on debt) alongside higher utility bills and a high stock of household debt.

What to watch over the next week?

The US Federal Reserve meet next week and are expected to announce a start to balance sheet roll-off which means a tapering in the reinvestment of maturing assets (Treasury and mortgage backed securities). The market has (so far) taken the Fed’s announcement of balance sheet roll-off as a non-event. While the beginning of the process will probably have limited implications on markets, the medium-long run impact will be upside pressure on yields and the impact on 10-year bond yields could be a lift by ~10 basis points once balance sheet roll-off is well under way. The September meeting will also include an update to the Fed’s “dot plots” that show members’ expectations for rate changes. The dot plots may show less support for a rate hike in December 2017 because of mixed inflation readings over recent months, but we think that the “median” voter will still indicate that a December rate hike is on the cards. The dot plots for 2018 and 2019 should show three hikes in each year, which is unchanged from recent Fed forecasts. Other US data next week includes numerous housing indicators (starts, existing home sales and home prices) and the September manufacturing PMI indicator.

The Bank of Japan (BoJ) meet next week and it’s expected that there will be no change to monetary policy. Japanese growth is slowly improving, but inflation is still too low (annual price growth is close to zero) which will keep monetary policy very easy in Japan for a long time.

There is little European data, which only includes the September PMI.

There are some RBA updates next week with the September Board minutes and Governor Philip Lowe speaking about “The Next Chapter” at a briefing in Perth, which is likely to be about Australia’s transition to a less mining intensive economy. Commentary around a strong Australian dollar may be present in next week’s minutes and speeches, given the persistent (and unexpected) strength in the currency.

New Zealand second quarter GDP is expected to increase by 0.8%, or 2.5% over the year. The outcome of the New Zealand election (on 23rd September) is looking tighter with the latest polls showing gaining support for the Labour Party (at 44%) compared to 40% for the incumbent National Party.

Outlook for markets

Share markets remain at risk of a further consolidation or short term correction, particularly with North Korean risks remaining high and seasonal weakness around September and October. However, with valuations remaining okay, particularly outside of the US, global monetary conditions remaining easy and profits improving on the back of stronger global growth, we would see a pullback as just a correction with the broad rising trend in share markets remaining in place into 2018.

Low yields point to ongoing low 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.

National residential property price gains are expected to slow, as the heat comes out of Sydney and Melbourne.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.

While further short term upside in the A$ is possible, our view remains that the downtrend from 2011 will ultimately resume as the Fed tightens and the RBA holds.