Investment markets and key developments over the past week
Financial markets saw a bout of renewed worries about US Federal Reserve (Fed) interest rate hikes in the past week but shares managed to shrug it off and end higher. Over the week US and European shares rose 0.3%, Japanese shares rose 2% helped by a fall in the yen, Chinese shares inched up 0.1% and Australian shares rose 0.4% led by health care and energy shares. In fact, for the year-to-date the Australian share market at +1% is outperforming US, European, Japanese and Chinese shares. Bond yields generally rose as investors moved to factor in a higher probability of a Fed interest rate hike next month and this also saw the US dollar push higher again. While the stronger US dollar weighed on the Australian dollar and metal prices, the oil price managed to gain 3%.
After five months of a lot of noise but inaction, the Fed is clearly edging towards another interest rate hike, with the June meeting “live” for a hike and a move in the summer looking likely. The minutes from the Fed’s last meeting were far more hawkish than the statement released immediately after the meeting, the key comment being that most Fed meeting participants felt that a hike at the Fed’s June 14-15 meeting would likely be appropriate if incoming data was supportive. In recent weeks it’s arguable that recent data has been supportive of a hike with signs that June quarter gross domestic product (GDP) growth is picking up, continued labour market strength and inflation edging towards the 2% target. So quite clearly the June meeting will see serious consideration given to a hike and this has seen the US money market’s probability of a June hike move up to 28% from close to zero only a week or so ago.
My view is that while a June Fed hike is now a close call, a July or September move is more likely because: the Brexit vote will take place just one week after the June meeting and several Fed officials have indicated that the Fed will consider that; Fed voting members appear to be more cautious than the full range of Fed meeting participants who include non-voting regional presidents who tend to be more hawkish; and the Fed will likely need more time to assess recent data releases which have only just started to improve again. So at this stage our base case is for a July move.
More broadly we remain of the view that Fed hikes will be very gradual with constrained global growth and the risk that the US dollar will start to surge higher again creating renewed weakness in commodity prices, renminbi deprecation, pressure on emerging countries and a brake on US growth all acting to constrain by how much and how quickly the Fed can hike.
Ho hum PEFO. The Australian Pre-election Economic and Fiscal Outlook was a bit boring in that it was based on the same underlying assumptions that were in the Federal Budget because the economic and fiscal outlook “has not materially changed” since the Budget on May 3. So as a result the budget deficit projections are identical as those in the Budget. Fair enough, but a couple of risks seem to have heightened since the Budget. First, wages growth has slowed to a new record low of 2.1% and is now running well below the assumed 2.5% wages growth for the year ahead. Related to this the Budget/PEFO inflation assumptions are now above those of the Reserve Bank of Australia (RBA). Second, the iron ore price has fallen 13% since the Budget making the Budget/PEFO iron ore price assumption of $US55/tonne look a little less secure. So the risk with the PEFO projections as with the Budget is that the assumed 6% per annum plus revenue growth will not be achieved and so the return of the Budget to surplus will be pushed out even further. Unfortunately, the whole PEFO process lost significant credibility around the 2013 Federal election with the new Coalition Government revising up the budget deficit projections over the four year forward estimates compared to the 2013 PEFO by a total of $68 billion just four months after PEFO was released.
What’s happened to autumn? In Sydney it’s been more like summer lately which reminds me we are still in the grip of a serious El Nino weather phenomenon. An El Nino sees trade winds that normally blow across the Pacific to the west (La Nina) weaken or reverse causing more rain in the east Pacific and less rain/drought in the west Pacific. The Southern Oscillation Index which measures sea surface pressures across the Pacific and is one indicator of it remains deep in El Nino territory, pointing to lower farm production and higher food prices, but so far there hasn’t been much sign of this. As we have seen in the past the link between El Nino and farm production varies, but it’s still worth keeping an eye on.
Source: ABS, AMP Capital
Major global economic events and implications
US data was a bit messy with softer readings for regional manufacturing conditions surveys, a bounce in industrial production in April but after two months of falls, home builder conditions and housing starts basically trending sideways but a fall back in jobless claims and stronger leading economic indicators and existing home sales. The overall impression though is that GDP growth is bouncing back, albeit modestly, after the March quarter’s slow down to 0.5% annualised growth. The Atlanta Fed’s GDPNow growth tracker is currently estimating 2.5% annualised growth for this quarter. Consumer Price Index (CPI) inflation bounced in April due to higher oil prices but core inflation dipped slightly to 2.1% year-on-year.
Japanese GDP rose more than expected in the March quarter as did machine orders but growth has been bouncing between positive and negative quarters against a zero growth trend for the last year now and the Kumamoto earthquake may be a bit of a dampener in the current quarter.
China saw the housing market continue to hot up in April, particularly in Tier 1 cities. Meanwhile, the People’s Bank of China moved to try and dampen down concern about the sharp slowing in credit seen in April indicating that the drop was temporary and that it will continue to support growth. Clearly it doesn’t want sentiment to swing back to the negative on China again. Our base case remains that Chinese growth will come in around or a bit above 6.5% this year. No boom but no bust either.
Australian economic events and implications
In Australia, while the minutes from the RBA’s last Board meeting were interpreted as suggesting that the RBA would not be rushing to cut interest rates again as it awaits “further information”, March data showing a new record low in wages growth suggests that another rate cut as early as June or July is possible. While labour market data for April was pretty much as expected, increasing signs of softness after last year’s strength – declining hours worked, falling full time jobs and mixed indicators from forward looking labour market indicators – also support the case for further monetary easing. So we remain of the view that the RBA will cut rates two more times this year taking the cash rate down to 1.25%. Our base case for the next move is August but it could come earlier.
What to watch over the next week?
In the US, the focus will be a speech by Fed Chair Janet Yellen (Friday) for any guidance regarding the prospects for a rate hike at the Fed’s June 14-15 meeting. While the latest Fed minutes indicated that the June meeting is “live” for a possible hike, Yellen is likely to be a bit more cautious. On the data front expect: the manufacturing conditions PMI (Monday) to remain around an index reading of 51; a bounce in new home sales (Tuesday); continuing gains in home prices (Wednesday); modest growth in durable goods orders and a slight rise in pending home sales (both Thursday); and an upwards revision to March quarter GDP growth to 0.8% annualised from the initially reported 0.5%.
In the Eurozone, May business conditions PMIs (Monday) are likely to remain around levels associated with continued moderate economic growth.
In Japan an improvement in the manufacturing conditions PMI (Tuesday) will be looked for and CPI data (Friday) is likely to show deepening deflation at a headline level and very low inflation on a core basis.
In Australia, March quarter construction data (Wednesday) and capex data (Thursday) are likely to show continued softness in business investment led by mining. Capex intentions for 2016-17 will hopefully show signs of improvement in non-mining investment though, consistent with reasonable business conditions of late. A speech by RBA Governor Steven’s (Tuesday) will also be watched for any clues regarding the interest rate outlook.
Outlook for markets
Expect short-term share market volatility to remain high. Fed worries are coming back into focus and this could mean more uncertainty around the US dollar, renminbi and commodity prices and the old saying “sell in May and go away, come back on St Leger’s Day” always adds to nervousness around this time of year. However, beyond near term volatility, we still see shares trending higher this year helped by a combination of relatively attractive valuations, further global monetary easing and continuing moderate global economic growth.
Very low bond yields point to a soft medium term return potential from them, but it’s hard to get bearish in a world of fragile growth, spare capacity and low inflation.
Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors.
Capital city residential property price gains are expected to slow to around 3% this year, as the heat comes out of Sydney and Melbourne. Prices are likely to continue to fall in Perth and Darwin, but price growth is likely to pick up in Brisbane.
Cash and bank deposits are likely to provide poor returns – and are getting even poorer!
After its recent fall from $US0.78 the Australian dollar is technically oversold and due for a bounce. However, any bounce is likely to be limited and the longer term downtrend looks to be resuming: the interest rate differential in favour of Australia narrows as the RBA continues cutting the cash rate and the Fed eventually resumes hiking, commodity prices remain in a secular downswing and the Australian dollar undertakes its usual undershoot of fair value.