Market Update 15 February 2019

Investment markets and key developments over the past week

Global share markets rose over the past week, helped by further progress on US-China trade talks, the US averting a renewed partial government shutdown, along with okay earnings results. US shares rose 2.5%, Eurozone shares gained 3.5%, Japanese shares climbed 2.5% and Chinese shares rose 2.8%. Australian shares dipped 0.1%, although they outperformed sharply in the previous week. Bond yields were flat- to-up a little bit. Oil, gold and metal prices rose, but iron ore prices fell. The $A rose above $US0.71, despite a stronger $US.

Further progress in US-China trade talks and the avoidance of a return to the partial government shutdown in the US are both positive to the extent that they help dial down the political risk that weighed on investors last year. The latest trade talks in Beijing ended with President Xi noting “important progress” and US Trade Negotiator Lighthizer saying “we have made headway”, as well as reports that the US and China had reached consensus on the main issues. The talks will continue in Washington in the week ahead, but are unlikely to be finalised until Presidents Xi and Trump meet, probably next month. If the March 1 tariff deadline is delayed, as appears probable, it’s likely that the US auto tariff threat will also be delayed, as Trump has been inclined to avoid multiple battles at once. Avoiding a return to the shutdown – even as Trump goes down the contentious path of declaring a National Emergency to get ‘The Wall’ funded - is good news, as it removes a threat to the economy. It also adds a bit to confidence that a debilitating battle, over the need to raise the debt ceiling from March, will be avoided.

Some lessening of political threats (for now), along with a swing to more dovish/stimulatory economic policy globally, are consistent with our view that this will be a decent year for share markets. However, with share markets having run hard from their December lows becoming technically overbought and with economic data still weak, the risk of a short term pull back is high. The Australian share market, in particular, looks to have run ahead of itself. Earnings results have been better than feared, but economic growth looks to be slowing, the earnings outlook is constrained, and the Reserve Bank of Australia (RBA) rate cuts are still a way off.

Major global economic events and implications
US data was messy over the past week. Retail sales fell sharply in December, possibly reflecting the impact of the shutdown and share market falls at the time; industrial production fell sharply in January; small business confidence continued to fall; and jobless claims rose, continuing a rising trend. Against this, manufacturing conditions rose in the New York region in February; consumer sentiment rose in February; and job openings and hiring remained strong. Meanwhile, headline inflation was weak thanks to falling energy prices, but core inflation was flat at 2.2% year-on-year and with momentum accelerating again. The weakness in retail sales and industrial production is consistent with the US Federal Reserve (Fed) pausing, but the pick-up in some more forward-looking indicators and acceleration in core Consumer Price Index (CPI) inflation in recent months, means that it’s premature to conclude that the Fed has finished tightening for this cycle. We expect the Fed to be on hold for the next six months, with maybe one hike later this year.

The US December quarter earnings reporting season continued to surprise on the upside over the past week, but it’s still showing a slowdown from previous quarters, as the tax boost and underlying earnings growth has slowed. 80% of S&P 500 companies have now reported, with 71% beating earnings estimates, with an average beat of 3.2% and 60% beating sales estimates. Earnings growth is running at 18.5% year-on-year for the quarter. As can be seen in the next chart, the level of surprises and earnings growth are slowing down. US earnings growth is likely to be around 5% this year.

Eurozone December quarter Gross Domestic Product (GDP) growth was confirmed at 0.2% quarter-on-quarter or 1.2% year-on-year. Germany just missed out on falling into a technical recession, with growth of just 0.02% quarter-on-quarter. Pressure on the European Central Bank and the German government for more stimulus is intensifying. Spain’s April 28 election is unlikely to lead to renewed worries about a break up of the Euro, with the Eurosceptic Podemos party running at just 15% support, but it could signal more conflict with Catalonia if right-wing parties do well.

Japan’s economy grew again in the December quarter, after a natural disaster affected September quarter. But GDP was flat compared to a year ago. That said, inventory, trade and public investment were the drags on growth and consumption & investment were solid. The Bank of Japan will still have to keep the ‘pedal to the metal’.

Chinese exports and imports bounced back in January, suggesting that things aren’t as bad as feared. That said, it would be wrong to get too excited either way, as the Lunar New Year holiday is known to distort Chinese data around this time of year. Meanwhile, inflation continued to fall and lending growth rebounded strongly in January, including a huge surge in corporate lending, indicating that policy easing is starting to flow through.

Australian economic events and implications
After weeks of poor data, Australian data was mixed over the past week. On the positive side, the National Australia Bank survey measure of business conditions and consumer confidence bounced back in January and February respectively, although both remain at uninspiring levels. Pressure remains on the housing market, with housing finance sliding sharply in January. There are reports that China has moved to make it even tougher for its citizens to move money out of China destined for property markets in Australia and elsewhere. In addition, the Australian Securities and Investments Commission is moving to toughen up its regulatory guidance for lenders, to the effect that Household Expenditure Measure benchmarks are too low an estimate of borrowers’ living expenses and that actual verification of income is required. In terms of the latter, while many lenders have already moved in this direction, its likely that there is still further to go in terms of tightening up lending standards.

The Australian December half earnings reporting season has been better than feared, but shows a slowdown in growth and caution regarding the outlook. So far, about a third of results have been released. 60% of companies have seen their share price outperform on the day of reporting (which is above the long-term norm of 54%) and 45% have surprised analyst expectations on the upside, which is around the long-term average. However, a more than normal 33% have surprised on the downside, the proportion of companies seeing profits up from a year ago has fallen, and only 55% have raised their dividends, which is a sign of reduced confidence in the outlook as six months ago it was running at 77%. Concern remains most intense around the housing downturn and consumer spending.

What to watch over the next week?
In the US, expect the minutes from the Fed’s last meeting (Thursday) to confirm that it remains upbeat, but that it’s waiting patiently to decide what to do next in terms of interest rates and that it might end its quantitative tightening process earlier than previously expected. On the data front, expect a slight rise in the National Association of Homebuilders’ conditions index (Tuesday), a modest rebound in underlying durable goods orders, business conditions Purchasing Managers’ Indexes (PMIs) for February to remain around 54-55 and existing home sales (all due Thursday) to rise slightly.

In the Eurozone, the focus will be on whether the business conditions PMIs (Thursday) show signs of trying to stabilise, after falling through most of last year, or continue to fall.

Japanese inflation data for January is expected to show core inflation rising slightly but only to 0.4% year-on-year.

In Australia, the minutes from the last RBA board meeting (Tuesday) will confirm the shift to a neutral bias in the immediate outlook for interest rates and Governor Lowe’s parliamentary testimony on Friday will be watched for further clues about how the RBA is seeing the outlook for the economy. On the data front, expect December quarter wages growth (Wednesday) to hold around 0.6% quarter-on-quarter or 2.3% year-on-year, as the lift in the minimum wage increase to 3.5% continues to feed through. January jobs data is expected to show a 5000 gain in employment and a rise in unemployment to 5.1%. Data for skilled vacancies and the February Commonwealth Bank of Australia business conditions PMIs will also be released.

The Australian December-half earnings results season will see its busiest week, with 70 major companies reporting including Ansell, Brambles and Coles (Monday), BHP, Bluescope and Cochlear (Tuesday), Fortescue, Stockland, Seven Group and Woolworths (Wednesday), and Coca-Cola Amatil, Nine and Wesfarmers (Thursday). 2018-19 consensus earnings growth expectations are around 4% for the market as a whole. Resources, building materials, insurance and healthcare look to be the strongest sectors, with telcos, discretionary retail, media and transport the weakest sectors, and banks constrained.

Outlook for investment markets
Shares are likely to see volatility remain high, with the high risk of a short-term pull back. However, valuations are okay, and reasonable growth and profits should support decent gains through 2019 as a whole, helped by more policy stimulus in China and Europe, as well as the Fed pausing.

Low yields are likely to see low returns from bonds, but they continue to provide an excellent portfolio diversifier.

Unlisted commercial property and infrastructure are likely to see a slowing in returns over the year ahead. This is likely to be particularly the case for Australian retail property.

National capital city house prices are expected to fall another 5-10% this year, led again by 15% or so price falls in Sydney and Melbourne. These falls are on the back of tight credit, rising supply, reduced foreign demand, price falls feeding on themselves and uncertainty around the impact of tax changes under a Labor Government.

Cash and bank deposits are likely to provide poor returns, as the RBA cuts the official cash rate to 1% by the end of 2019.

The $A is likely to fall into the $US0.60s as the gap between the RBA’s cash rate and the US Fed Funds rate will likely push further into negative territory as the RBA moves to cut rates. Being short the $A remains a good hedge against things going wrong globally.