Investment markets and key developments over the past week
Share markets had a messy week as the return of growth worries weighed, with Japanese shares down 3.4%, Eurozone shares down 2.6%, Chinese shares down 0.9% and US shares losing 0.4%. Despite falls in commodity prices and some earnings downgrades from the banks, including one cutting its dividend, Australian shares rose 0.8% helped by the RBA’s rate cut and an implicit easing bias in its statement on monetary policy (SOMP). Global growth concerns also pushed bond yields down, weighed on commodity prices and, helped along with the RBA’s rate cut, pushed the Australian dollar down by 3%. While the US dollar rebounded, its rise just looks like normal volatility in a downtrend.
Donald Trump wins the Republican primaries. So much for my view that Donald Trump won't get a majority of delegates leading to a contested GOP (Republican) convention. Cruz and Kasich have now dropped out. So it seems hurling around divisive abuse and advancing play-school solutions to complex problems is the way to secure the Republican nomination (Mexicans and Chinese are rapists, implicating Cruz's father in the assassination of JFK, etc.). This must be hard for decent Republicans. Fortunately polls, particularly of independents who will decide the outcome at the presidential election, show Hilary Clinton (who only needs 15% of remaining delegates from Democrat primaries to secure a majority) well ahead of Trump. The trouble is that Trump will now try and swing back to the centre (i.e., tone down his rhetoric - if that is possible!) and a potential upset (e.g., a terrorist attack on US soil leading to support for a "strong man", a US recession or criminal charges against Hillary Clinton in relation to her use of emails as Secretary of State) means that a common sense victory in the US presidential election six months away is not assured.
Apart from big changes to superannuation, the Australian 2016-17 Federal Budget was rather uninspiring, with trivial income tax cuts and nothing really new in terms of contributions to long-term economic growth. Sure, there's A$50 billion in infrastructure spend over six years but only just over A$1 billion of that is new. The plan to reduce corporate tax rates for small business is welcome but for large business it will be a long time coming. The real focus of the budget seemed to be on presenting the government as "fair" (hence the super hit to higher income earners) ahead of the 2 July election.
The changes to superannuation are consistent with the move to set its objective as providing income in retirement and they still leave superannuation as highly tax preferred compared to alternatives. The concern though is that yet another big change to super and the retrospective nature of some of those changes will further affect confidence in it, likely pushing the perception of super as the “wisest place for saving” in the Westpac/MI consumer survey to another new low. It also has the potential to adversely affect the supply of patient long-term saving available to help grow the Australian economy, further dampening incentive in the economy because it’s a de-facto tax hike for high income earners at a time when the Australian tax system is already highly progressive (the top 5% already contribute 33% of tax revenue). The moves may also push funds into other strategies such as negative gearing.
Source: Westpac/Melb Institute Consumer Survey, AMP Capital
RBA cuts the cash rate to a record low of 1.75%, more to come. In cutting for the twelfth time in this rate cutting cycle, which started in November 2011, the RBA cited a lower outlook for inflation. This was after the much lower than expected March quarter inflation outcome and the RBA backed its decision up in its quarterly statement on monetary policy (SOMP) by lowering its inflation forecasts for this year to just 1-2%, and to 1.5-2.5% for 2017 and into 2018. A desire to see a lower Australian dollar was arguably another consideration. While the RBA’s SOMP made no substantive changes to its growth forecasts, which see growth running around 3%, it is rightly concerned about preventing sub-target inflation from becoming entrenched in expectations and the associated risk that this could drift into sustained deflation, a la Japan. It would also prefer to manage any risk of reinvigorating home price strength in Sydney and Melbourne via macro prudential regulation rather than run the risk of leaving interest rates too high. With the RBA’s ultra-low inflation forecasts being based on market expectations for one more rate cut at the time the SOMP was prepared, the implication is that the cash rate may have to fall even further (to maybe 1%) to be confident that inflation will return to within the target range. So by implication the RBA has signalled a strong easing bias. Given the downside risks around inflation, the upside risks for the Australian dollar if the US Federal Reserve (the Fed) continues to delay, and continued weak demand growth, we see another rate cut around August, with the high risk of another move in November.
The announcement that RBA Deputy Governor Philip Lowe will replace Glenn Stevens as Governor in September is no surprise and welcome. Dr Lowe’s expertise and experience at the RBA leaves him well placed for the role. He has a similar approach to Glenn Steven’s so it’s hard to see significant changes to the operation of monetary policy. Meanwhile, Glenn Steven’s huge contribution to macro-economic stability in Australia should be acknowledged. While the RBA has made some mistakes on rates these are minor and it has quickly changed tack once it has worked out its mistake – e.g., through the global financial crisis and the recent easing cycle. More broadly, Glenn Stevens’ quick rate cuts in 2008-09 played a huge role in Australia avoiding the recession that hit all other OECD countries. At the same time, RBA monetary policy has helped anchor inflation around the target zone of 2-3%. While some may criticise Governor Stevens for overseeing housing bubbles and poor affordability, these problems owe to the poor housing supply response rather than monetary policy settings.
In Australia, the Prime Minister also formally called the Federal election for 2 July. Since this has been widely expected the uncertainty elections create is likely already reflected in consumer and business confidence and the share market. Elections can have the impact of delaying spending decisions by households and businesses but the impact tends to be temporary. That said, this is a longer campaign than normal and there seems to be more at stake this time around, especially around public spending, taxes, negative gearing and the banks so the impact of the election may be greater this time. The good news is that looking at all elections since 1983, while the share market has shown a tendency to track sideways through election campaigns, it has had an average gain of 4.9% over the three months after elections.
Major global economic events and implications
US data was mixed with weaker manufacturing conditions in April and soft payroll employment, but stronger services sector conditions, stronger construction activity, and a smaller trade deficit. The April jobs report, showing a weaker than expected gain in payrolls of 160,000, will no doubt add to fears about a US slowdown and so a June Fed rate hike is now even less likely and the chance of a July move is low as well. However, monthly payrolls can be volatile. The soft April gain may be payback for mild weather in the March quarter. Jobless claims are around their lowest level since 1973 and wages and hours worked were stronger. Therefore, it would be wrong to read too much into the soft headline April payroll increase. Meanwhile, the US March quarter profit reporting season is now 87% done. Results generally have been better than expected, with 76% beating on earnings and 54% beating on revenue, but not by much, as earnings growth for the quarter has only improved to -7.4% year-on-year from around -9.5%.
Chinese business conditions PMIs fell back slightly in April. Fortunately, they remain above recent lows and the moves were too minor to read much into. The overall impression remains that China is not going to have a bust but it won't be rebounding either. Meanwhile, home prices rose again in April as inventory levels continue to fall. Quite clearly the "ghost city" bust of a few years ago came to nothing and the property market is getting hot again.
Australian economic events and implications
Australia saw mainly solid data over the last week with another bounce in building approvals (albeit the trend remains down), solid home price gains in April, a rebound in new home sales, modest growth in retail sales and a sharp improvement in the trade deficit for March. In fact, net exports look like contributing around 0.75% or so to March quarter GDP growth as resource export volumes along with services exports surge. So the recession some still look for is likely to remain elusive. But there was a slight slippage in business conditions in April.
What to watch over the next week?
In the US, expect to see a rebound in April retail sales, after weakness in March, with reasonably solid core retail sales growth, a slight improvement in consumer sentiment and continued low producer price inflation (all due Friday). Data on small business optimism and job openings will also be released.
Chinese economic activity indicators, due 14 May, will be watched closely to see if the improvement in momentum seen in March has continued into April. Slight setbacks in business conditions PMIs suggest that they are likely to be mixed though, with a slight slowing in industrial production (to 6.5% yoy from 6.8%), little change in retail sales growth (at around 10.5%) and a continued pick-up in investment growth. Credit and money supply growth is likely to have remained strong. While CPI inflation is likely to remain around 2.3% year on year, producer price deflation is likely to continue to abate.
In Australia, expect the latest RBA rate cut and the modest tax cuts in the budget to have driven a rebound in consumer confidence (Wednesday) after April’s fall and March housing finance to reverse the gain seen in February. A speech by the RBA’s Malcolm Edey (Thursday) will be watched for clues on interest rates.
Outlook for markets
Expect short term share market volatility to remain high. May always seems to be a nervous time as now everyone knows about “sell in May and go away, come back on St Leger’s Day”. Global growth remains fragile and uncertainty lingers around the Fed. 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 – getting even poorer!
The ongoing delay in Fed tightening still poses short-term upside risks for the Australian dollar. However, any short-term rebound is likely to be limited and the longer-term downtrend looks to be resuming as the interest rate differential in favour of Australia narrows, as the RBA cuts 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.