Investment markets and key developments over the past week
Share markets continued to recover over the last week. While initially coming under pressure from ongoing worries about inflation and the US Federal Reserve (the Fed), US shares rose sharply on Friday, resulting in a 0.6% gain for the week. Eurozone shares gained 0.3% for the week, Japanese shares rose 0.8%, Chinese shares rose 2.6% and Australian shares rose 1.6%, helped by solid profit results. After initially rising, US bond yields ended flat for the week and yields fell in core Europe, Japan and Australia. Yields rose in Spain and Italy, as the Italian election on 4th March is injecting renewed political risk into Italy. Commodity prices were mixed with oil and iron ore up, but metals down, not helped by a bounce in the US$. The stronger US dollar also saw the A$ fall.
We remain of the view that the pullback in share markets this month is a correction as opposed to the start of a new bear market. However share markets could still have a retest of recent lows and markets are likely to remain volatile as it will take a while for investors to fully adjust to higher inflation, a more aggressive Fed and higher bond yields. Meanwhile, a more aggressive Fed and strengthening growth in the US relative to the rest of the world (with US PMIs rising this month relative to Eurozone and Japanese PMIs) could at least drive a further bounce higher in the US$, particularly with sentiment towards the US$ so negative that it’s positive from a contrarian perspective. This is at a time when the US Fed Funds rate is set to rise above the Reserve Bank of Australia’s (RBA) cash rate next month for the first time since the early 2000s, which is likely to push the A$ lower.
The Italian election on 4th March is unlikely to threaten the euro for now (although markets might worry about it) but it’s not likely to be good for economic reform either. Italian shares have been star performers over the last year, reflecting an improvement in the Italian economy and banks. The coming election could threaten this. Polling indicates that no single party or existing coalition will reach the 40% threshold to win government, so another election is possible. However, the incentive to build coalitions is strong and there are three potential coalition government outcomes: a populist right-wing coalition including Silvio Berlusconi’s (no – he can’t be Prime Minister again!) centre-right Forza Italia and the right wing Northern League (which looks the closest to the 40% threshold); a “grand coalition” between Forza Italia and the centre-left Democratic Party with maybe the Northern League and formerly Eurosceptic Five Star Movement (5SM); and a centre-left coalition with the Democratic Party and 5SM.
While 5SM (a lot) and the Northern League (a bit) have toned down their Euroscepticism to the point that an Italian euro exit is no longer really on the agenda for now, all major parties are promising more government spending (which is not great given Italy’s high public debt) and prospects for stepped up economic reforms are low. A populist right-wing coalition would be the most negative outcome as both Forza Italia and the Northern League have promised big spending and threatened to reverse economic reforms and it would run the risk of an attempt to leave the euro during the next economic downturn (with the Northern League arguably now the most Eurosceptic of the major parties, even though it has toned it down). A grand coalition would really just mean more muddling along in Italy with little economic reform and it would be the most unstable. A centre-left coalition would arguably be the most positive in terms of being a bit more fiscally sensible and 5SM is actually pro-reform, but it’s also the least likely outcome. Overall, the Italian election is unlikely to threaten an Itexit (an Italian exit from the euro) at least in the short term, but it does run the risk of making Italy’s public finances worse than they already are (with increased conflict with Brussels as a result) and no progress in addressing Italy’s long-term competitiveness problems. Not great – but probably not enough to threaten the greater European integration agenda that Germany and France are likely to pursue (assuming the Merkel/SPD coalition is confirmed by a majority of SPD members with the result to also be announced on 4th March!).
The RBA is well aware of mortgage stress in setting interest rates, but it won’t stop them raising rates when needed as it’s not as bad as often portrayed. The common impression given by various media reports in recent years is that mortgage stress is so bad that any rise in interest rates will cause mass defaults, a collapse in home prices and big problems for the banks. However, the RBA in a speech by Assistant Governor Michele Bullock points out that mortgage stress is in fact little changed, and even down a bit over the last decade (with lower interest rates offsetting higher principle payments). While it is keeping a close eye on the issue, it also notes that higher debt levels will be allowed for in setting rates. The bottom line is that the RBA does not see mortgage stress as a barrier to raising interest rates when the need arises, but higher debt levels than in the past likely mean that the next tightening cycle will be mild by past standards. This is simply because higher debt has made household spending more sensitive to rate moves, and as a result rates simply won’t need to go up as much as in the past to achieve a desired slowing in spending in order to contain inflation.
Major global economic events and implications
US economic data was solid, and the Fed is more confident. While existing home sales fell in January, this may have more to do with low supply and in any case Markit business conditions PMIs for February rose solidly, the Conference Board’s index of leading indicators is surging and jobless claims remain ultra-low, all pointing to continued strength in economic growth. Meanwhile, the minutes from the Fed’s last meeting retained a bit of scepticism about whether inflation would rise, but overall indicated more confidence in the growth and inflation outlook. And note that this was before the recent data showing stronger wages growth and inflation and Congress’ further fiscal stimulus. While the Fed may still be thinking in terms of three hikes this year, we remain of the view that it will end up hiking four (or possibly five) times, whereas the US money market is still factoring in three hikes.
The December quarter US earnings reporting season is now 90% completed and has continued to impress. 78% of results have beaten earnings expectations and 77% have beaten on sales. Earnings growth for the quarter is up 15% year-on-year and revenue is up 8% year-on-year.
Eurozone business conditions PMIs and consumer confidence slipped in February but remain very strong, pointing to continuing strong growth.Japan’s Nikkei manufacturing conditions index fell slightly in February but remains solid indicating continued good growth. Core inflation rose slightly in January which is good, however at 0.4% year-on-year it’s still a long way below the 2% inflation target, so the Bank of Japan is still a long way from starting to wind back monetary stimulus.
Australian economic events and implications
Yet again, Australian economic data was mixed over the last week. On the one hand, an uptick in December quarter wages growth is not quite as good as it looks – it was trivial with annual wages growth still just 2.1% year-on-year, likely to reflect the ongoing flow through of last year’s minimum wage rise with underlying wages growth stuck around 1.9% year-on-year and was focussed on the public sector, with no uplift in private sector wages growth. The best that can really be said is that wages growth has stabilised. With significant spare capacity remaining in the labour market and enterprise agreements still showing falling wages growth, it’s premature to expect much of a lift in wages growth just yet. So there is nothing in this or the minutes from the RBA’s last board meeting to change our expectation that interest rates won’t be increased until late this year at the earliest.
On the other hand, a sharp slump in construction activity in the December quarter is nowhere near as bad as it looks. In fact, it just reflects the removal of a technicality that saw imported LNG installations artificially boost engineering construction in the prior two quarters, which as with the previous quarters will have no impact on GDP growth. Estimates of underlying construction were around flat for the quarter, with a rise in non-residential building but a fall in residential and public construction.
The highest share of Australian companies seeing profit gains since the GFC, but profit growth is still lagging globally - where profit growth is running around 14%. The December half profit reporting season is around 90% done and has been pretty good. 46% of results have exceeded expectations (against a norm of 44%), 73% of companies have seen profits rise from a year ago (compared to a norm of 65%) which is the strongest since the GFC and 66% have increased dividends from a year ago with 27% keeping them flat which is a sign of ongoing confidence in the outlook. Reflecting the reasonable quality of results, 57% of companies have seen their share price outperform the market the day results were released (against a norm of 54%). Partly reflecting the uncertainty around the global correction in share prices, good beats were greeted with sharp share price gains particularly when PEs were low (e.g. Nine and Qantas) and misses were hit hard (e.g. Blackmores). Consensus profit growth expectations for this financial year remain around 7%, with resources upgraded slightly to 15% and the rest of the market downgraded to 5% (from 6%) owing to a downgrade to banks. Profit expectations for 2018-19 were actually upgraded to 5% (from 4%) thanks to resources.
What to watch over the next week?
In the US, the focus will be back on the Fed and inflation, and there may be a bit of nervousness ahead of new Fed Chair Powell’s first monetary policy Congressional testimony starting on Tuesday, particularly in relation to his comments around fiscal easing in the US and the impact of this on interest rate increases. I expect that the combination of recent wages and inflation data along with further fiscal easing will add to Powell’s confidence in the growth and inflation outlook leaving the impression that gradual rate hikes will continue, but that the Fed is starting to lean towards four hikes this year rather than the three in the “dot plot”.
On inflation, the core private consumption deflator for January (which is the Fed’s preferred inflation measure) on Thursday is likely to show a lift of 0.3% month-on-month, but with a similar rise dropping out a year ago the annual rate is likely to remain at 1.5% year-on-year. Meanwhile, expect to see continuing strength in new home sales (Monday), durable goods orders, home prices and consumer confidence (all Tuesday), pending home sales (Wednesday) and the ISM manufacturing conditions index (Thursday).
Eurozone economic confidence readings for February (Tuesday) are expected to show continued strength and unemployment in January is likely to have fallen to 8.6% (from 8.7%) but core inflation (Wednesday) is likely to have remained around 1% year-on-year which will keep the European Central Bank pushing the pedal to the metal.
Japanese data is likely to show continued strength in industrial production (Wednesday) and in the labour market (Friday).
Chinese business conditions PMIs for February (Wednesday) are likely to have remained solid.
In Australia, the focus will be on business investment and home price data to be released Thursday. Expect December quarter business investment to have risen by around 1% in the December quarter, and investment intentions data to show further signs of a lift in non-mining investment. CoreLogic home price data for January is likely to show a further decline in Sydney and Melbourne home prices but flat/moderate growth elsewhere. Meanwhile expect continued moderate growth in credit (Wednesday) and continued solid readings for business conditions PMIs (Thursday).
The Australian December half 2017 earnings reporting season will wrap up with around 20 major companies reporting including BlueScope and QBE (Monday) and Adelaide Brighton and Harvey Norman (Wednesday).
Outlook for markets
Volatility in share markets is likely to remain high with investors yet to fully digest the outlook for higher inflation and interest rates in the US, but the broad trend in share markets is likely to remain up as global recession is unlikely and earnings growth remains strong globally and solid in Australia. We remain of the view that the S&P/ASX 200 index will reach 6,300 by end 2018.
Low yields and capital losses from rising bond yields are likely to see low returns from bonds.
Unlisted commercial property and infrastructure are still likely to benefit from the search for yield by investors, but it is waning, and listed variants remain vulnerable to rising bond yields.
National capital city residential property price gains are expected to slow to around zero as the air continues to come out of the Sydney and Melbourne property boom and prices fall by around 5%, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms.
Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.
After reaching as high as US$0.8136 in January, which is near the top of the technical channel it’s been in since 2015, the A$ is on the way back down again against the US$, and this is likely to get a push along as the gap between the RBA’s cash rate and the US Fed Funds rate goes negative next month. Solid commodity prices will provide a floor for the A$ though.
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