Market Update 24 January 2020

Investment markets and key developments over the past week

This week equity markets were knocked around with worries about a flu pandemic spreading from China. Asian equities were the hardest hit, with Chinese shares down 3.6%, Hong Kong equities 3.8% lower, while Japanese equities fell by 0.3%. Euro stocks declined by 0.5% and US shares were initially resilient but ended up declining by 1.0% over the week (the largest weekly fall since August 2019) as more cases of the virus were found in the US. Australian equities managed to rise by 0.4% over the week. Globally, travel, insurance and luxury stocks were all negatively impacted. (More details on the virus below). Energy and metal commodities weakened on concern over the impact to Asian demand, but gold prices rose on safe-haven demand. US 10-year yields have fallen again to just under 1.7% and may fall further. The US$ rose and the A$ weakened marginally, to just over 0.68 US dollars.

The concern about a flu pandemic are originating from a new type of Coronavirus that has pneumonia-like symptoms, which started in the Chinese city of Wuhan, in the Hubei province (apparently from a seafood and wildlife market). To date, there have been 927 reported cases and 41 deaths (a mortality rate around 4%). The World Health Organisation has not declared a global health emergency, as the virus has been contained to China with only a few cases globally. Authorities have been proactive in taking steps to contain the spread of the virus (closing transport in Wuhan and cancelling Chinese New Year celebrations).

There have been numerous health scares in recent history (SARS, bird flu, swine Flu, MERS, Ebola). While the loss of life in these instances is tragic and the panic caused in affected regions impacts everyday life, the worst case scenario of a global pandemic like the 1918 Spanish Flu (that killed up to 50 million people) has not come to pass. For markets, investors should be concerned, but not panic just yet. While it is impossible to know exactly how much more the virus can spread, most epidemics have taken 6-18 months to run their course and then the actions taken by authorities (hygiene, quarantine, banning gatherings, preventing travel, etc) start having an impact. The 2003 impact of the SARS outbreak was shorter due to rapid action by authorities. The quick reaction by Chinese authorities this time round is reason for optimism.

Comparing the current episode to SARS is useful. The 2003 SARS outbreak infected 8000 people, mostly in Asia, in 30 countries over 5 months at a mortality rate of 10%. While the number infected was not that great, SARS had a big negative impact on countries economic activity. GDP in Hong Kong and Singapore in the June quarter 2003 fell by over 2% as people stayed home (lower retail sales), missed work and travel was cancelled. Growth then rebounded.

Asian shares fell in April 2003 even though global shares were rising. Usually the share market low coincides with a peak in the number of new cases (see chart below) so there is a risk that Asian equities fall further.

This time round, the risk to disrupting economic growth is high because of the Chinese New Year holiday period starting (this weekend) and the associated spending that goes with it (travel, eating out, retail sales). It’s also happening around the same time that China and emerging markets economies are showing signs of stronger growth, with the virus having the ability to disrupt activity. The other point to note is that the mortality rate (so far) for the new Coronavirus is lower at 4% compared to SARS (10%) and much lower than Ebola (at 50% and higher).

There were some interesting comments from President Trump at the World Economic Forum in Davos this week around the possibility of new tax cuts. Trump may well put a new tax cut into his re-election campaign which could involve a payroll tax cut or expanding the Earned Income Tax credit. This would contrast with most of the Democratic front-runners who are campaigning on tax increases. Treasury Secretary Mnuchin also said that further Chinese reforms may be met with some tariff cuts – watch this space.

The International Monetary Fund (IMF) downgraded its world growth forecasts in its January economic outlook update. Global growth is now expected to increase by 3.3% in 2020 (down from 3.4% previously forecast) and 3.4% in 2021 (previously 3.6%) but this is still a decent improvement on 2019 (where global growth rose by 2.9%). We are slightly more pessimistic than the IMF (3.2% growth in 2020 and 3.3% in 2021) and the IMF has tended to revise down its growth forecasts over recent years (see chart below).

Major global economic events and implications

The January US Markit manufacturing PMI disappointed expectations (at 51.7) but is still well over 50 which indicates expansionary conditions. Services PMI readings remain strong. Existing home sales had a good rise in December and initial jobless claims in mid-January remained low, a good sign for employment growth.

The Bank of Canada left policy unchanged but sounded more dovish and there is the risk of an interest rate cut later this year.

The Bank of Japan kept monetary policy unchanged this week while the December inflation data showed a slight tick up in core inflation to 0.9% year-on-year (from 0.8% last month). The manufacturing PMI improved to 49.3, higher than expected.

The European Central Bank meeting this week saw no major surprises, with interest rates and the asset purchase program remaining unchanged. Downside risks to growth have decreased since December and there has been a “modest” increase in underlying inflation. European manufacturing conditions are improving, with the flash PMI for January rising to 47.8 and with a decent lift in German manufacturing, which has been the source of weakness in Europe.

New Zealand December quarter CPI was a bit stronger than expected, rising by 0.5% over the quarter and 1.9% year-on-year.

Australian economic events and implications

Australian consumer sentiment in January fell by 1.8% and is around its lowest levels since mid-2015 (see chart below).

The CBA PMI’s weakened for services (to 48.9) and fell slightly for manufacturing (to 49.1). Skilled vacancies according to the Department of Employment and Workplace relations rose by 0.6%, which was in line with the surprisingly good December employment data. Employment increased by 28.9K in December, driven by part-time jobs (+29.2K) while full-time jobs fell by 300. The unexpected strength in jobs growth pushed the unemployment rate down to 5.1% (from 5.2% last month), which is the lowest unemployment rate since March 2019.  

There are still reasons to be cautious on the employment outlook. Residential construction is still declining which is negative for jobs growth. Our jobs leading indicator (see chart below) is still indicating some further weakness in employment growth (but not a collapse).

However, the trend down in the unemployment rate towards the end of 2019 gives the Reserve Bank of Australia (RBA) room to wait to cut interest rates, given that monitoring trends in the labour market has been a key focus for the RBA. We think that the RBA should cut the cash rate at its February meeting (Australia is still a long way from “full” employment, with labour underutilisation at 13.4%, inflation remains low, there will be a negative impact to growth from the bushfires, GDP growth is likely to be revised down in the RBA’s quarterly statement and there are negative risks to global growth from the new Coronavirus), but the improvement in the labour market and friendlier global growth environment means it’s a close call and we now expect the RBA to delay cutting the cash rate until March. This could change with the December quarter inflation data (more on that below) if underlying inflation misses the RBA's forecast of 1.6% annual growth. Market pricing is now only expecting a 25% chance of a rate cut in February, well down from the 55% a week ago.

What to watch over the next week?

In the US, December new and pending home sales are released, as are durable goods orders, January consumer confidence, and December quarter GDP data. GDP is expected to have increased by a solid 2.2% (annualised) rate in December. The Federal Reserve meet next week and no change to policy is expected. Powell will give a press conference post meeting.

In Europe, the December unemployment rate will be out, as will December quarter GDP and January core inflation data. Eurozone data remains soft, but an improvement in global manufacturing this year should lift growth. German January IFO data is released next week (a good guide to business conditions) and should show some improvement in activity. The Bank of England meet next week and are expected to cut interest rates by 0.25% to 0.5% as an insurance cut given the low growth and inflation environment.

In Australia, the December quarter inflation data is expected to show headline inflation up by 0.5% in the December quarter, or 1.7% year-on-year. The RBA’s preferred “trimmed mean” measure of core inflation should show quarterly growth of 0.4% or 1.6% over the year, which is very low and has now been missing the target since 2014. Other price data includes December quarter producer prices and import/export price data. December credit data is expected to rise by 0.2% over the month, driven by housing credit. December NAB business confidence/conditions may be negatively impacted by the hit to activity by the fires.

In China, the official manufacturing PMI for January is expected to weaken slightly for both manufacturing and services, but remain in line with annual GDP growth around 6%.

In Japan, the December unemployment rate is expected to remain very low at 2.3%, while December industrial production should show a small rebound over the month.

Outlook for markets

Improving global growth and still easy monetary conditions should drive reasonable investment returns through 2020, but they are likely to be more modest than the double-digit gains of 2019 as the starting point of higher valuations for shares and geopolitical risks are likely to constrain gains and create some volatility:

• After very strong gains and with investor sentiment now bullish, shares are due for a short-term correction or consolidation. 
• For the year as a whole however, global shares are expected to see total returns around 9.5% helped by better growth and easy monetary policy. 
• Cyclical, non-US and emerging market shares are likely to outperform, particularly if the US dollar declines and trade threat recedes as we expect.
• Australian shares are likely to do okay this year, but with total returns also constrained to around 9% given sub-par economic & profit growth.  
• Low starting point yields and a slight rise in yields through the year are likely to result in low returns from bonds.
• Unlisted commercial property and infrastructure are likely to continue benefitting from the search for yield, but the decline in retail property values will still weigh on property returns. 
• National capital city house prices are expected to see continued strong gains into early 2020 on the back of pent up demand, rate cuts and the fear of missing out. However, poor affordability, the weak economy and still tight lending standards are expected to see the pace of gains slow, leaving property prices up 10% for the year as a whole. 
• Cash & bank deposits are likely to provide very poor returns, with the RBA expected to cut the cash rate to 0.25%.
• The A$ is likely to fall to around $US0.65 as the RBA eases further, but then drift up a bit as global growth improves to end 2020 little changed.