Investment markets and key developments over the past week
The past week saw most major share markets continue to push higher helped by the lessening in geopolitical risks around trade and Brexit and a solid start to US September quarter earnings reports. US shares rose 0.5%, Eurozone shares gained 0.3% and Japanese shares rose 3.2%. Chinese shares fell 1.1% partly on the back of soft economic data. Australian shares also rose by 0.7% with solid gains in energy, health, consumer discretionary, industrial and financial shares but a sharp fall in material stocks and reduced expectations for rate cuts held the market back. Bond yields generally rose as growth fears continued to recede a bit. Commodity prices were mixed with copper up but oil and iron ore down. The Australian dollar rose on reduced expectations for near term rate cuts and as the US$ fell.
US/China tensions continued to fester over the last week, with the details of the Phase One mini trade deal yet to be finalised and issues around Hong Kong not helping. But it looks like HK is being treated separately to the trade issue and Chinese officials have confirmed that they are still working on the text of the trade deal with US negotiators. The trade issue could still have flare ups, but the intense economic pressure on both sides to de-escalate means that we have probably seen the worst in terms of trade war angst, at least until after the US election next year.
The UK and EU agree a Brexit deal – whether it will pass the UK parliament remains a big uncertainty, but the risk of a no-deal Brexit has now fallen sharply given that PM Johnson is now supporting a deal. The new deal gets around some of the issues associated with the Irish backstop but it’s far from certain that Johnson has the numbers to get it through parliament but because he has agreed a deal it substantially reduces the risk of a no deal Brexit. Meanwhile, the UK parliament has forced Johnson to request an extension to Brexit from the EU to 31 January and a vote on Johnson’s Brexit deal has been delayed but is likely in the week ahead. Going forward there look to be three possible scenarios:
- First, parliament supports the deal allowing the UK to exit by 31 October with a transition period that continues existing UK/EU relations until a new trading relationship is agreed. Of course, this still involves significant longer-term uncertainty until the relationship is resolved but a sudden hard Brexit is avoided for now at least and so it would be a positive for the UK economy.
- Second, parliament rejects the deal and imposes a referendum between Johnson’s deal and no Brexit.
- Third, parliament rejects the deal and calls a new election where the effective choice would be between Johnson’s deal and a referendum or no Brexit.
The second and third scenarios involve a lot more short-term uncertainty, but the point is that with Johnson swinging behind a Brexit deal the risk of a no deal Brexit has fallen sharply. Brexit is still a comedy for those outside the UK – particularly given that it’s taken over three years to get to this point and still the longer term relationship between the UK and EU has not be resolved - and just remember that this a much bigger issue for the UK (as 46% of its exports go to the EU) than it is for the EU (which has just 6% of its exports going to the UK) now that the risk of Brexit contributing to a contagion of countries exiting the Eurozone has collapsed.
The IMF revised down its global growth forecasts yet again to 3% for this year and 3.4% for next – this is just catching up to the reality as already reflected in share market volatility, lower bond yields and central bank easing. After a brief interruption through 2017 we are back to the pattern seen through much of this decade which has seen initial optimism for growth of around 4% for the year ahead give way to downwards revisions to around 3%. The downside is that stronger growth remains elusive, but the upside is that it prevents the build up of excess in areas like inflation and so keeps the investment cycle going.
Market expectations for further RBA rate cuts for this year fell sharply over the last week, but it looks like an over reaction to us. The hawkish turn in rate cut expectations reflects a combination of the RBA minutes running through the arguments against further rate cuts, a slightly better than expected jobs report for September, RBA Governor Lowe emphasising the RBA’s upbeat view on the economy seeing a return to trend growth next year and a return to optimism in global financial markets generally after the recent lessening in geopolitical risks. Our view is that while September’s slight fall in unemployment may have bought the RBA a bit of breathing space and that the list of positives Governor Lowe refers to will help avoid a recession, we doubt growth will be strong enough to achieve full employment and get inflation back to target anytime soon. The following points are worth noting:
- Labour market underutilisation is still very high at 13.5% and has had to fall all the way to 6.9% in the US just to get 2.9% wages growth, so Australia has a long way to go before it gets to full employment and decent wages growth.
- Forward looking labour market indicators like job vacancies are pointing to weaker employment growth ahead suggesting that unemployment is unlikely to fall anytime soon.
- The drag on growth from falling housing construction will likely continue to weigh more on economic growth than the RBA is allowing for.
- Interest rate and tax cuts to date will help growth but so far the impact looks to be pretty muted.
- The IMF’s downwardly revised Australian growth forecasts for this year and next of 1.7% and 2.3% respectively point to the likelihood of more downward revisions to the RBA’s growth forecasts next month (with the RBA currently forecasting growth of 2% this year and 2.75% next year).
- While the minutes from the last RBA board meeting discussed various popular arguments against rate cuts, the RBA dismissed them, then cut anyway and reaffirmed a preparedness to ease again if needed so I don’t think they really change anything.
- Governor Lowe’s comments regarding the outlook are consistent with the RBA’s own forecasts and often discussed views so aren’t really new. Maybe he just sounded a bit more upbeat than he has been lately. But it is worth noting that those forecasts are built on the assumption of another rate cut and even then they fall short of achieving full employment.
- Governor Lowe’s comment about negative interest rates being “extraordinarily unlikely” in Australia and a move to negative rates are “not the assumption I’d encourage” are consistent with the RBA’s earlier expressed scepticism about the value of negative rates. But its noteworthy that he did not say the same about quantitative easing suggesting it remains an option it would consider. (Note – media reports initially indicated that Governor Lowe talked down more rate cuts but his comments which were in response to a question were in relation to negative interest rates and other unorthodox monetary policies, so I have adjusted my comments here from the first edition of this report.)
It’s understandable that the Governor may want to talk the economy up with a “glass half full assessment” to prevent sentiment becoming too negative and self-fulfilling. The RBA often does this. But as we have seen this year the RBA will continue to act if it’s not achieving its mandate. Ideally, fiscal stimulus should be stepping in, but it still looks a long way off in Australia with the Government still focussing on the budget surplus and “keeping our powder dry”, so pressure will continue to fall on the RBA. Prospects for a November rate cut have fallen over the last week, but later this month we are likely to see another Fed rate cut and another subdued September quarter inflation report, so we are continuing to pencil in another rate cut for Melbourne Cup day. And we remain of the view that the cash rate will fall to 0.25% by early next year. If the Fed cuts again this month and the RBA doesn’t follow up with another rate cut in November it will only see the A$ rebound further which will make its job of boosting growth even harder.
RBA not too worried about rising house prices. A speech by Assistant Governor Debelle also downplayed concerns about rate cuts and rising house prices driving financial stability concerns - as long as credit growth remained low and lending standards remained strong, which suggests that rising house prices won’t on their own prevent further RBA easing.
Major global economic events and implications
US data was a mixed bag. Retail sales were soft in September although the previous month was revised up and real consumer spending growth looks to have been solid in the September quarter. Industrial production fell in September, albeit after a solid rise in August but the mixed readings for manufacturing conditions in October in the New York and Philadelphia regions suggest on balance that manufacturing conditions continue to remain soft. Housing starts fell back in September, but this was after a huge rise in August, the trend is rising and permits and home builder conditions point to more upside ahead. Lower bond yields have clearly boosted the US housing sector. Finally, jobless claims continue to remain ultra-low.
US September quarter earnings off to a solid start. While only 15% of S&P500 companies have reported to date, so far so good with 84% beating earnings expectations by an average of 3.9% and 66% beating on sales, suggesting that earnings growth for the last year will end up slightly positive.
Chinese growth slowed further in the September quarter to 6% year on year, but there are some positive signs suggesting the slowdown will be constrained. The trade war is clearly impacting, and this was evident in further falls in exports and imports with exports to the US and imports from the US down 22%yoy and 16%yoy respectively. Against this though annual growth momentum in September picked up slightly in retail sales and industrial production and credit and money supply growth were stronger than expected suggesting that monetary easing may be flowing through.
Japanese core inflation actually slipped to just 0.5%yoy in September, which is well below the 2% inflation target.
Australian economic events and implications
Australian jobs data for September was a bit better than expected, but not enough to change the outlook. Employment rose by 15,000 with a rebound in full time jobs and both unemployment and underemployment fell slightly. This may give the RBA a bit of breathing space. But unemployment only fell because of a small fall in participation, the combination of unemployment and underemployment remains very high at 13.5% compared to just 6.9% in the US and leading jobs indicators point to a slowing in employment growth ahead. Our view remains that growth is unlikely to be strong enough going forward to achieve full employment and the inflation target and so the pressure remains for further policy stimulus.
What to watch over the next week?
In the US, the main focus will be on October business conditions PMIs to be released Thursday and which are expected to show further signs of stabilisation. In other data expect to see a slight pull back in a rising trend for existing home sales (Tuesday) and new home sales (Thursday) and a fall in durable goods orders (also Thursday). The September quarter earnings reporting season will start to ramp up in the week ahead with consensus expectations for a roughly -2.4% year on year decline in earnings per share led by energy, materials and tech stocks with revenue growth of roughly 1.6%yoy. Assuming normal beats this suggests earnings growth will come in around +1%yoy.
The ECB meeting on Thursday is unlikely to provide any new insight on the significant easing package announced at the ECB’s September meeting. However, it will be Mario Draghi’s last as President before Christine Lagarde takes over and may see Draghi reflect on the experiences of his eight-year term. His key legacy has been the preservation of the Euro through his 2012 commitment to do “whatever it takes” which he vigorously backed up by the deployment of a range of new monetary policy tools and constantly berating politicians to do more. All of which enabled the Eurozone to stay together and emerge from the Eurozone debt crisis strengthened and more integrated. Under Draghi’s watch Eurozone unemployment has fallen from a high of 12.1% to 7.4% now, despite a long period of fiscal austerity. Eurozone business conditions PMIs to be released Thursday for October will be watched for signs of improvement after their sharp leg down in September.
Japanese business conditions PMIs will also be released Thursday.
In Australia data for skilled vacancies (Wednesday) and the CBA’s business conditions PMIs for October (Thursday) will be released.
Outlook for investment markets
Share markets remain at risk of further volatility in the months ahead given issues around trade, Iran & the Middle East, impeachment noise and weak global economic data. But valuations are okay – particularly against low bond yields, global growth indicators are expected to improve by next year and monetary and fiscal policy are becoming more supportive all of which should support decent gains for share markets on a 6-12 month horizon.
Low yields are likely to see low returns from bonds once their yields bottom out, but government bonds remain excellent portfolio diversifiers.
Unlisted commercial property and infrastructure are likely to see reasonable returns. Although retail property is weak, lower 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 rise in national average capital city home prices led by Sydney and Melbourne. But beyond an initial bounce, home price gains are likely to be constrained through next year as lending standards remain tight, the record supply of units continues to impact and rising unemployment acts as a constraint.
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.
The A$ is likely to fall further to around US$0.65 as the RBA cuts rates further. Excessive A$ short positions, still high iron ore prices and Fed easing will provide some support though with occasional bounces and will likely prevent an A$ crash.
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