Investment markets and key developments over the past week
The past week saw most major share markets rebound as investors refocussed a bit away from the geopolitical soap operas back to favourable underlying global growth. This saw US shares gain 1.6%, Japanese shares rise 2.4% and Chinese shares gain 0.2%, although Eurozone shares fell 0.2% as Italian shares remained under pressure. Australian shares rose 0.9% benefitting from the positive US lead with resources shares leading the charge back up but yield sensitive utilities, telcos and real estate shares under some pressure. With the return to “risk on” bond yields rose, which was accentuated by indications that the ECB is getting closer to phasing out its bond buying program. Commodity prices also rose and this along with some better local data saw the A$ rise slightly. Some emerging markets remained under pressure though – notably Brazil and Turkey.
Has Trump’s fiscal stimulus set up a Wile E. Coyote moment for the US economy to go off a cliff in 2020 and look down as Ben Bernanke suggests and should investors worry? To some degree yes – but it’s a lot more complicated that Bernanke suggests. Bernanke is expressing the frustration US central bankers would be feeling that the fiscal stimulus has come at a time when the US economy is already strong and so this means the Fed may have to tighten more in the short term than would otherwise be the case. And around 2020 is the time we would be cautious on the US economy. But against this is all a bit academic and it’s way too early for investors to get too worried about it just yet. The US economy is still a long way from exhibiting the excesses that would set up for a downturn – cyclical spending in the economy is still below pre-recession excesses, wages growth is still low, inflation is far from excessive and monetary policy is still easy. We are still waiting for clear evidence of the stimulus to hit the economy. And when it does it will add to profits, which is actually good for the share market. Moreover, it’s not clear that the impact of the fiscal stimulus will suddenly stop in 2020, particularly if it sets up a cycle of stronger business investment which could keep the economy going longer. So while Bernanke’s comments feed into the end of cycle fears of investors it’s still a bit premature to get too concerned about it.
Trade angst continues – but this still doesn’t feel anything like 1929 (or 1971). Nervousness around global trade continued over the last week with the latest round of US-China trade talks in Beijing ending without a joint statement, talk that the US may engage in bilateral talks with Mexico and Canada which would effectively kill NAFTA and the G7 meetings turned into a G6 versus the US regarding trade – highlighting a widening gulf between the US and its allies. However, two things are worth noting. First it does seem that the US and China are making incremental progress on their trade dispute. There has been no negative comment from the US and there has been talk they may be trading objectives in terms of how much China will buy from the US. There is a good chance that while the US will provide the final list of Chinese imports to be subject to a 25% tariff on June 15, implementation will be delayed. Second, the US tariffs at around 3% of total imports are a non-event compared to US tariff hikes of 1929 and 1971 which covered virtually all imports and their tax revenue is trivial compared to the fiscal stimulus being pumped into the US. So even if they are implemented and there is proportional retaliation we are a long way from a full-blown trade war.
Italy clearly remains an issue. Sure an early election has been averted (for now) but the new Government’s proposed 6% of GDP fiscal easing leaves it on a collision course with the European Commission and arguably with bond markets. It will take a while, but the problem will likely come to a head by September 20 when the Government will present its budget for evaluation. Anticipating this Italian bond yields have shot up again and this will weigh on Italian shares and the Euro given the risk that conflict over the budget could morph into talk of an Itexit. However, given the difficulties involved in leaving the Euro and popular support for it, ultimately Italy will likely stay in and so a fiscal compromise will be reached. On this front two things are worth noting. Firstly, the European Commission will probably provide Italy with a bit of leeway. Secondly, German Chancellor Merkel is starting to lend support to some of French President Macron’s proposals for strengthening the Eurozone including support for a European Monetary Fund, an investment budget and strengthened Frontex border control. This is very positive for the Eurozone and could form part of a broader compromise with Italy.
Meanwhile, the ECB looks on track to phase down its quantitative easing program in the December quarter, with an announcement possible at its meeting in the week ahead. The ECB looks to have to come to the view that it doesn’t want to be seen encouraging an irresponsible budget blow out in Italy. It’s also worth noting that the ECB has already been phasing down its QE program – it was cut from €80bn a month to €60bn a month for last year and then to €30bn a month for this year to September and as with the Fed an end to QE does not mean rate hikes are imminent. In fact, the ECB is likely to stress that rate hikes remain a long way off, and an ECB rate hike may not come until 2020. And if things go pear shaped they can always start up QE again.
Why the concerns about emerging markets? This basically reflects a combination of country specific problems (eg Turkey, Brazil and South Africa), concerns that the rising US$ will cause a dollar funding crisis for emerging countries with significant US$ debt, worries that they will be adversely affected by any global trade war and valuation concerns after a 65% rally in emerging market shares from early 2016 to early this year took them from cheap to modestly expensive. The risk is that the weakness in some emerging market shares and currencies has further to run as many of these concerns remain.
Short term bank funding costs settling back down in the US – but not in Australia. This is surprising given that it was the rise in US short term funding costs that drove up Australian short-term funding costs…but if it’s sustained it will put pressure on Australian banks to raise some mortgage rates as banks source 20% of their funding from this source.
Major global economic events and implications
US data remains strong with a rebound in the non-manufacturing conditions ISM index, continuing strength in job openings, ongoing low jobless claims and the trade deficit falling to its lowest since September last year. In fact, the US now has more job openings than there are unemployed people! The Atlanta Fed’s tracker of GDP growth for this quarter puts it at 4.5% annualised. While this is after just 2.1% in the first quarter it’s consistent with ongoing upwards pressure on interest rates.
German factory orders fell for the fourth month in a row in April and industrial production also fell highlighting the softer tone in Eurozone economic data this year – all of which is Euro negative and is an argument for the ECB to wait a bit longer before deciding what to do with its QE program.
Japanese household spending, the services conditions PMI and Economy Watchers confidence indicators fell suggesting weak activity may have continued into the June quarter.
Chinese May export growth stayed strong at 12.6% yoy and import growth rose to 26%, indicating that domestic demand is strong.
Australian economic events and implications
After weeks of softness Australian data showed pleasing strength over the last week, but it’s unlikely to be sustained. March quarter GDP growth of 1% quarter on quarter or 3.1% year on year, April retail sales and ANZ job ads all rose more than expected and the trade surplus remained solid in April. It would be premature to break out the champagne though. In recent years the Australian economy has seen several quarterly growth spikes to 1% or so only to see growth slip back again. March quarter growth was driven by a combination of public spending, dwelling investment, stockpiling and export volumes all of which won’t be sustained and in the meantime consumer spending is likely to remain constrained by low wages growth, tightening bank lending standards, higher petrol prices and a negative wealth effect from falling home prices. So we remain of the view that growth will average just below 3% going forward. Good – but not good enough to cut into high levels of unemployment and underemployment. As a result, we remain of the view that the RBA won’t be raising rates until at least 2020.
What to watch over the next week?
The coming week will be a busy one with the US-North Korean summit, the US due to announce a final list of US$50bn of Chinese imports to be covered by a 25% tariff on Friday, the Fed, European Central Bank and Bank of Japan meeting along with the usual flow of economic data.
If the US-North Korean summit makes no progress markets will react negatively but not dramatically as there is a lot of scepticism around the summit. More likely is that some sort of progress towards an agreement for North Korea to phase down its nuclear capabilities will be achieved, as otherwise neither side would have agreed to participate in the first place.
On the trade front, while the US may announce the finalised list of Chinese imports to be subject tariffs on Friday, it may delay implementation if negotiations are progressing well.
In the US, the Fed (Wednesday) is likely to raise rates another 0.25% to a range of 1.75%-2% for the eighth hike this cycle. The Fed will no doubt acknowledge uncertainties around trade and Italy and of course it is responsive to global developments – as we saw in 2016. So, they probably won’t hike five times this year! But a range of indicators show that the US economy is strong, that the labour market is very tight and that inflationary pressures are slowly building and so it makes sense to continue the process of gradually raising rates to more normal levels. It will only take one official to move from three hikes this year to four to see the “dot plot” go from three hikes this year to four – but whether this happens or not is a coin toss. But regardless we remain of the view that the Fed will also hike in September and December taking it to four hikes this year. Meanwhile, on the data front in the US expect to see May core inflation (Tuesday) edge up to 2.2% yoy and retail sales (Thursday) and industrial production (Friday) to remain strong.
The ECB (Thursday) is not expected to make any changes to its monetary policy but it will be watched to see what it says about the Italian situation and whether it provides any guidance as to what it will do with its quantitative easing program after the current guidance ends in September. In relation to the latter the most likely outcome is an announcement that it will phase it down through the December quarter but stress that interest rate hikes are a long way off.
Meanwhile the Bank of Japan is expected to make no changes to its monetary stimulus program. With core inflation falling back to 0.4% year on year in April there is no sign of any move to the exit doors from easy money.
Chinese economic activity data (Thursday) is expected to show a slowing in industrial production to 6.8% year on year, investment growth unchanged at 7% and retail sales growth picking up to 9.7%.
In Australia, expect April housing finance to fall 1.5%, the NAB business survey to show continuing strength in business conditions (both Tuesday), consumer confidence data (Wednesday) to show a slight bounce (with good growth data offsetting news of falling home prices) and May jobs data (Thursday) to show a 10,000 gain but unemployment falling back slightly to 5.5%. Meanwhile, speeches by RBA Governor Lowe (Wednesday) and Assistant Governor Ellis (Friday) will be watched for any clues on interest rates.
Outlook for markets
Volatility in share markets is expected to stay high as US inflation and interest rates move up and as issues around President Trump (trade, Mueller inquiry, etc) continue to impact, but the medium-term 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 continue to expect the S&P/ASX 200 Index to reach 6300 by end 2018.
Low yields and capital losses from rising bond yields are likely to drive low returns from bonds. Australian bonds are likely to outperform global bonds helped by the relatively dovish RBA.
Unlisted commercial property and infrastructure are still likely to benefit from the search for yield, but it is waning, and listed variants are vulnerable to rising bond yields.
National capital city residential property prices are expected to slow further as the air continues to come out of the Sydney and Melbourne property boom and prices fall by another 4% this year, 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%.
The A$ likely has more downside to around US$0.70 as the gap between the RBA’s cash rate and the US Fed Funds rate pushes further into negative territory. Solid commodity prices should provide a floor for the A$ though.
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