Investment markets and key developments over the past week
While share markets bounced from oversold levels early in the past week, they fell back to varying degrees as worries around US interest rates, the US trade conflict with China, tech stocks and Italy’s budget deficit continued, along with tensions with Saudi Arabia regarding a missing journalist. This left share markets mixed, with Eurozone shares up 0.3% and Australian shares up 0.7%, but US shares flat, Japanese shares down 0.7% and Chinese shares down 1.1%. Bond yields rose slightly in the US, but were flat to down elsewhere. While oil and metal prices fell, gold and iron ore rose. Despite a rise in the US dollar, the Australian dollar was little changed.
Bull markets are characterised by relatively steady gains, punctuated by occasional sharp pull backs as investors periodically cut their long positions on the back on adverse news events. Our view remains that recent falls represent a correction, but of course it remains premature to conclude that we have seen the bottom, given the worry list around US interest rates, trade, oil prices, etc.
The minutes from the US Federal Reserve’s (the Fed’s) last meeting provided a reminder that the median Fed official, as per their ‘dot plot’, expects to gradually raise the Fed Funds rate to around 3.4% over the next two years. This is just above what it regards as ‘neutral’ (ie around 3%). Market expectations for a hike to 2.85% over two years remain too dovish, indicating that bond yields still have more upside, but as we have seen since yields bottomed in 2016, this will likely come in fits and starts.
The US Treasury refrained from naming China as manipulating its currency and it has been confirmed that President Trump and Chinese Leader Xi, will meet on the sidelines of the November 29 G20 Summit, but this does not mean the trade conflict is about to ease up. The currency decision was to be expected because the Renminbi does not meet all the US Treasury criteria to be defined as being ‘manipulated’. That said, the report was critical of China and its ‘increasing reliance on non-market mechanisms’, which means the US may still name it for manipulating its currency next year. A Trump-Xi meeting is positive, but the gap between the two is huge and so our base case remains that further escalation is likely.
US/Saudi tensions over the murder of a journalist pose a new risk and could easily get a lot worse before it gets better, but ultimately it’s doubtful President Trump or Saudi Arabia will sacrifice the US trade relationship with Saudi Arabia (given the threat to oil prices), or that Saudi Arabia will counter-retaliate to the extent that it adversely affects US support for it against Iran.
And something completely different - is the ‘gig economy’ just imagined? The term sounds cool and gets bandied around to explain things like low wages growth, but it’s doubtful it really exists. As the Reserve Bank of Australia’s Alex Heath pointed out last week, casual employment (ie workers without sick leave and holiday pay) in Australia has been around 20% of the workforce since the 1990s and the share of independent contractors has fallen over the last decade. In the US, the share of self employed in total employment has fallen from 14% to 6% over the last 70 years and workers are in their jobs for longer than 30 yrs ago. So, there is not a lot of evidence of the gig economy.
Major global economic events and implications
US economic activity data was mostly strong. Housing starts fell as Hurricane Florence impacted, but strength in the home builders’ conditions index, released by the National Association of Home Builders, points to a rebound. Retail sales were weaker than expected in September, but record high job openings and very strong hiring, points to ongoing labour market strength, which should support consumer spending. Industrial production rose solidly in September and regional manufacturing conditions indexes remained strong in October. In addition, the US leading indicator for September continues to point to strong growth, and jobless claims remain ultra-low. Meanwhile, the September quarter profit-reporting season is off to a strong start, with 87% of results so far exceeding profit expectations and 65% beating on revenue. That said, only 85 of the 500 companies in the S&P 500 Index have reported so far. But profits look like they will yet again beat market expectations for a 21% year-on-year rise and come in around 24%.
On the political front in Europe, the details of Italy’s budget plans were not as bad as feared, reducing the risk of a full speed ‘head on’ with the European Commission. Also, the Christian Social Union’s loss in Bavaria was not as bad as feared, together taking a bit off pressure off Chancellor Merkel. So, no Euro disaster brewing on either front.
UK Brexit uncertainty continues, with the Irish border remaining a sticking point. The risk of a ‘no-deal Brexit’ (which would probably knock the United Kingdom into recession), a new election, or another referendum is significant, but some sort of last-minute deal that punts off details for a future resolution remains the most likely scenario. It’s hardly ever that such deals are resolved ahead of when they really need to be! It’s too early to get bullish on the British pound though.
Chinese economic growth slowed in the September quarter, with GDP growth slowing to 6.5% year-on-year and monthly data coming in mixed, with weaker industrial production and credit growth, but stronger retail sales and investment, and lower unemployment. The slowdown reflects a crackdown on ‘shadow banking’ and tariff uncertainty. While it’s consistent with our forecast for Chinese growth to slow to 6.5% this year, the trade threat suggests the risks are still on the downside and that further policy stimulus is likely. Meanwhile, falling producer price inflation and core consumer price inflation of just 1.7% year-on-year provide no barrier to further policy stimulus.
Australian economic events and implications
Another confusing jobs report in Australia – but it’s mostly strong. The September jobs report showed soft employment growth, but continuing strength in full-time jobs and a sharp fall in unemployment to 5%. There are good reasons to be a bit sceptical about the plunge in the unemployment rate as sample rotation looks to have played a role, and monthly jobs data is known for volatility. That said, jobs growth running around 2.3% year-on-year is still strong, leading jobs indicators are still solid and it’s hard to deny the downtrend in unemployment. So, the Reserve Bank of Australia can rightly feel happy that this is going in the right direction. Against this though, the US experience has been that unemployment will need to fall a lot further to spark stronger wages growth, and the combination of unemployment and underemployment remains very high in Australia at 13.3% compared to 7.5% in the US.
More broadly there seems to be a tussle in Australia between booming infrastructure spending, improving business investment, bottoming mining investment and falling unemployment on the one hand, versus falling home prices, peaking housing construction, uncertainty around consumer spending, high underemployment and weak wages growth on the other. The outcome is likely to be neither a growth boom nor bust, but rather constrained growth with the central bank continuing to leave interest rates on hold out to 2020 at least.
What to watch over the next week?
In the US, GDP data (Friday) will likely show that economic growth slowed in the September quarter to a 3.2% annual pace from 4.2% in the June quarter. June quarter growth was inflated by a bounce back from the seasonally weak March quarter, and Hurricane Florence is also likely to have dampened September quarter growth, so underlying growth is probably running around 3.5%. In other data, expect a further increase in home prices but a slight fall in new home sales (both Wednesday), October business conditions Purchasing Managers Indexes (also due Wednesday) to be solid, underlying durable goods orders to rise, but pending home sales to fall (both Thursday). The flow of September quarter earnings reports will also pick up.
The European Central Bank is not expected to make any changes to monetary policy at its meeting on Thursday. The loss of economic momentum, sub-par core inflation and global uncertainties are likely to see it delay any decision on finally ending quantitative easing, and leave the impression that interest rate hikes are still a long way off – probably not until 2020 in our view. Meanwhile, business conditions Purchasing Managers Indexes for October due on Wednesday are likely to have remained okay, around 54.
In Australia, only skilled vacancy data is due on Wednesday. There will be more interest on the political front given the result of the Wentworth by-election. While the Government should be able to hang on as a minority government, as we saw in August both the share and currency markets dollar don’t like political uncertainty.
Outlook for markets
We continue to see the trend in shares remaining up, as global growth remains solid helping drive good earnings growth, and monetary policy remains easy. However, the risk of a further short-term correction is high given the threats around trade, emerging market contagion, ongoing US rate hikes and rising bond yields, the Mueller inquiry, the US mid-term elections and Italian budget negotiations. Property price weakness and approaching election uncertainty add to the risks around Australian shares.
Low but rising yields are likely to drive low returns from bonds, with Australian bonds outperforming global bonds as the Reserve Bank of Australia maintains interest rates at current levels and the Fed hikes.
Unlisted commercial property and infrastructure are still likely to benefit from the search for yield, but it is waning.
National capital city residential property prices are expected to slow further, with Sydney and Melbourne property prices likely to fall another 15% or so, but Perth and Darwin property prices at or close to bottoming, and Hobart, Adelaide, Canberra and Brisbane seeing moderate gains.
Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.
While the A$ has now fallen close to our target of US$0.70, it likely still has more downside into the US$0.60s, as the gap between Australia’s cash rate and the US Fed Funds rate pushes further into negative territory as the US economy booms relative to Australia. Being short the A$ remains a good hedge against things going wrong in the global economy.
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