Market Update 1 Decemeber 2019

Investment markets and key developments over the past week

Share markets generally rose over the last week helped by optimism regarding a US/China trade deal and mostly okay economic data. US shares reached a new record high and rose 1.2% over the week, Eurozone shares gained 0.5% and Japanese shares rose 0.8%. Chinese shares by contrast fell 0.6%. Australian shares also broke out to a new record high and rose 2% helped by the positive global lead with strong gains in telcos, energy, health and IT stocks offsetting more constrained increases in consumer discretionary and financials with the issues around Westpac still impacting. Bond yields were little changed globally but they fell in Australia on the back of weak data and prospects for more monetary easing. While the iron ore price rose slightly, metal prices fell slightly but the oil price fell sharply on signs of weakening OPEC commitment to supply cuts. The Australian dollar fell slightly on prospects for more monetary easing even though the US dollar was little changed.

How can US and Australian shares be at record levels given all the economic and geopolitical uncertainty? It’s simple: the decline in interest rates and bond yields has made shares cheap and share markets are looking forward to a boost to growth and hence profits down the track from easier monetary policy. And don’t forget that the Australian share market has only just got above its 2007 pre GFC high so it’s taken 12 years…albeit the 2007 high was breached back in 2013 if dividends are allowed for which they should be given that dividends constitute a relatively high proportion of total returns from Australian shares.

The past week saw some more positives headlines on the US/China trade talks. China indicated a strengthening in intellectual property protection and that the latest trade talks were constructive with agreement to stay in contact on the remaining points of a deal and President Trump said the talks were in the “final throes”. Mr Trump’s signing into law of a bill supportive of HK demonstrators led to renewed uncertainty though. This need not de-rail the trade talks but may mean that the US might have to roll back more tariffs as part of the Phase 1 deal. Our assessment remains that the pressure on both sides to ease trade tensions – even if it’s just for 6-12 months – is now far more intense than has been the case over the last 18 months. The key to watch in the near term is the fate of the scheduled December 15 tariff hike.

The RBA’s roadmap for what it may do beyond cutting interest rates – QE yes but not on the radar (yet), negative rates still “extraordinarily unlikely”. With the official cash rate getting closer to zero it makes sense for the RBA to be thinking about what else it can do and it has clearly given a lot of thought to it with Governor Lowe providing a pretty comprehensive and transparent review of the options. The basic message from the RBA is that if further easing is needed it will first take the cash rate down to 0.25%. If additional stimulus is needed it would then consider quantitative easing (QE) but only if the economy is “moving away from, rather than towards, our goals for both full employment and inflation.” In doing so the RBA would buy only government bonds in the secondary market which rules out the direct financing of fiscal stimulus (ie helicopter money) and would not buy private sector assets. With financial markets including the banks’ access to funding operating normally it also ruled out liquidity measures (for now). This effectively rules out any immediate moves to buy bank bills, mortgage backed securities or provide cheap funding for banks to increase the pass through of rate cuts to borrowers. In addition, negative rates continue to be seen as “extraordinarily unlikely” (and righty so as it’s not clear that they work). Oddly enough Governor Lowe didn’t mention the scenario of neither moving away from nor getting closer to the RBA’s goals - which is basically the scenario we have been in for several years now.

Which brings us to where to from here? Given the recent run of weak data on jobs, retail sales, car sales, housing construction, business investment and credit, the RBA’s own forecasts for barely any progress towards reaching its goals over the next two years and that the RBA sees rate cuts as still working (with which I agree), it should be cutting rates again on Tuesday. Particularly so given that the next Board meeting is not till February. A speech by RBA Deputy Governor Debelle also highlighted the problem the RBA has with wages growth around “2 point something” becoming the norm because its well below the level necessary for sustained 2% to 3% inflation. In other words, inflation expectations may be becoming de-anchored from the inflation target. However, the Governor’s comments suggest little urgency and a preference to “wait and assess” given the “long and variable lags” of monetary policy. As a result, while the RBA should be cutting again on Tuesday and it’s a close call, on balance we now expect the next 0.25% rate cut to come in February and with growth likely to remain weaker than the RBA expects we see a final cut to 0.25% in March. Beyond which QE is likely, but the RBA will likely delay it until it sees if it gets any substantial further fiscal easing in the May Budget.

Major global economic events and implications

US economic data was generally pretty good. Pending home sales fell in October, but September quarter GDP growth was revised up slightly to 2.1%, October data showed solid gains in durable goods orders and personal spending, the trade deficit fell, consumer confidence slipped a bit in November but remains strong, home prices are rising, jobless claims fell pointing to continuing labour market strength and the Fed’s Beige Book of anecdotal evidence was a bit more upbeat on the economy. At the same time core consumption deflator inflation fell to 1.6% year on year in October. So, it looks like Goldilocks (ie not too hot, not too cold) remains alive and well. All of which will probably leave the Fed on hold at its December meeting.

Eurozone economic confidence and the German IFO business index rose slightly in November, adding support to the view that growth may be bottoming. Core inflation rose to 1.3%yoy in November but it’s likely to drift back down in the months ahead.

The Japanese labour market remained strong in October, but industrial production fell back sharply although its likely been distorted by the October sales tax hike.

China’s official composite business conditions PMI rose in November to its highest since March with gains in manufacturing and services, suggesting that growth may be stabilising.

Australian economic events and implications

Australian non-mining business investment continuing to disappoint. September quarter construction data showed a continuing fall in dwelling construction consistent with the fall in building approvals. But the big disappointment is the ongoing weakness in business investment. Non-residential building rose in the September quarter, but plant and equipment fell yet again. More significantly business investment plans for the current financial year imply a downgrade to the outlook with plans up only 2.5% on those made a year ago for 2018-19, which implies close to zero real growth. Mining investment looks on track for a strong rise, but non-mining investment looks likely to fall slightly.

Meanwhile private credit growth slowed further in October to its slowest rate since 2010 of 2.5%yoy. Annual growth in housing credit slowed to a record low of 3%yoy, but monthly data looks to be stabilising suggesting that a pick-up in new loans may be starting to offset the rapid pay down of existing housing debt. But with total housing credit growth remaining soft at 3%yoy it’s far from being a concern for the RBA from a financial stability perspective, so the housing market upswing is not yet a constraint on further RBA monetary easing.

What to watch over the next week?

In the US, payrolls for November due Friday are expected to bounce back with a 190,000 gain after the soft GM strike affected October result but unemployment is likely to remain at 3.6% with wages growth edging up to 3.1%yoy. In other data, expect a slight rise in the manufacturing conditions ISM (Monday), a slight fall in the non-manufacturing ISM (Wednesday) and a decline in the trade deficit (Thursday).

China’s Caixin manufacturing conditions PMI (Monday) is expected to fall slightly but the services PMI is likely to rise.

In Australia, the RBA should be cutting rates again on Tuesday given that it remains far away from its goals for full employment and inflation and is likely to remain so for the next two years, but looks likely to remain in “wait and assess” mode and leave rates on hold. It is a close call though. See the first section of this report for more details.

On the data front in Australia, expect September quarter GDP growth of 0.6% quarter on quarter or 1.7% year on year, but with net exports, public spending and inventories being the main drivers offsetting continued softness in consumer spending, housing investment and business investment. Not the best growth mix! In terms of other data expect another strong rise in November average home prices of around 1.6% as the unleashing of pent up demand post the election and rate cuts continues, a fall back in building approvals (Monday), another current account surplus and continued strength in public spending (Tuesday) and a fall back in the trade surplus and 0.2% rise in October retail sales (Thursday).

Outlook for investment markets

Share markets remain at risk of further short-term volatility given issues around trade, Iran, impeachment noise and mixed economic data. But we are now entering a period of positive seasonality with the Santa Claus rally often seen from mid-December. More fundamentally shares remains cheap against low bond yields, global growth is expected to improve through next year and monetary policy is easy all of which should support decent gains for shares on a 6-12 month horizon.

Low yields are likely to see low returns from bonds once their yields bottom out if they haven’t already, but government bonds remain excellent portfolio diversifiers.

Unlisted commercial property and infrastructure are likely to see reasonable returns. Although retail property is weak, low for longer bond yields will help underpin unlisted asset valuations.

The election outcome, rate cuts, tax cuts and the removal of the 7% mortgage rate test are driving a rebound in national average capital city home prices led by Sydney and Melbourne. But beyond an initial bounce which could run into first half next year, home price gains are likely to be constrained through this latest upcycle as lending standards remain tight and rising unemployment acts as a constraint. The risk though is that the recent surge in prices goes on for longer as property price gains in Australia have a habit of feeding on themselves.

Cash and bank deposits are likely to provide poor returns as the RBA cuts the official cash rate to 0.25% by early next year.

Our base case remains that the A$ still has more downside to around US$0.65 as the RBA eases further. However, with the US dollar looking like it may have peaked and given excessive A$ short positions there is a growing risk that we may have already seen the bottom (at US$0.6671 early in October).