Investment markets and key developments over the past week

Share markets rebounded over the past week as worries about Brexit leading to global financial and economic chaos faded somewhat. US shares rose 5.1%, Eurozone shares gained 3.9%, Japanese shares rose 4.9%, Chinese shares rose 2.5% and the Australian share market gained 2.6%. Despite ongoing political turmoil in the UK, the British share market surged 7.2% to its highest for the year helped by the plunging British pound and talk of Bank of England monetary easing. Bond yields continued to decline on lower for longer interest rate expectations but currency markets were a bit more stable (apart from the pound), credit spreads narrowed and commodity prices rose.

There have been several positive developments over the last week with respect to Brexit. Well maybe not for the UK, but in terms of the issue that really matters and that is the threat it poses to the rest of Europe and the global economy. First, the Spanish election actually saw support for the governing People’s Party increase with no gain for anti-establishment Podemos suggesting that the Brexit mayhem may have seen voters opt for stability. Of course PM Rajoy’s People’s Party still has to form a coalition government but the prospects are much higher than after the December election.

Second, two clear messages emerged from the European Union leader’s summit in the last week: it is looking to learn the lessons from the UK’s exit to better serve its citizens and strengthen the EU; and it is taking a firm stance with the UK – there can be no access to the benefits of free trade with the EU without meeting the obligations (the free movement of people, adoption of EU rules and regulations and contributing to its budget). In other words the UK will not be let off lightly which will send a strong signal to other potential exiteers.

Third, policy makers around the world have continued to swing into action with the Bank of England foreshadowing monetary easing, talk that the ECB is considering expanding its bond purchases, fresh stimulus in Korea, another rate cut in Taiwan and more moves towards stimulus in Japan.

Fourth, bond yields in Spain and Italy have fallen sharply to new record lows indicating that so far investors are not demanding a higher premium to invest in such countries. The threat of ECB “whatever it takes” intervention to preserve the Euro is helping.

Finally, assets vulnerable to a rising $US have not crashed. In fact oil has hung around $US50, copper is up, emerging market shares are ok. Credit spreads have not blown out. We don’t seem to be seeing a re-run the January-February panic.

Of course, the ride will remain rough for UK assets, although the British pound appears to be wearing the worst of that and it should be borne in mind that the UK is only 2.5% of global GDP. And uncertainty will remain regarding the risk of a domino effect of exits in the Eurozone - with the Italian Senate referendum in October and a re-run of the Austrian presidential election in September or October following a ruling by the Austrian Constitutional Court being the next big events to watch. But so far at least the threat from Brexit to the Eurozone and the rest of the world looks to be constrained.

In Australia, the election is finally over but it looks like another three years of de facto minority government which is not a great outcome for the economy and investment markets. While the Coalition looks to be slightly ahead in the seat count so far it looks very close and the outcome may not be known till Tuesday at the earliest. Even if the Coalition does win government it won’t have control of the Senate with the balance of power remaining with the Greens and minority “parties” which will act as a huge constraint on the government, which means another de facto minority government, i.e. more of the same. The end result will be poor prospects for getting government spending and the budget deficit under control over the next three years and for the Coalition implementing its policy to cut corporate taxes let alone undertaking serious productivity enhancing economic reforms. It looks next to impossible for a Coalition government to get enough votes to reinstate the Australian Building and Construction Commission.

Alternatively, if Labor wins it will likely mean faster public spending growth via more spending on health and education, partly funded by tax increases on higher income earners (retention of the budget deficit levy and cutbacks in access to negative gearing and the capital gains tax discount and superannuation savings similar to those of the Coalition although the details haven’t been spelt out) but a higher budget deficit in the next few years, a royal commission into banking and greater intervention in the economy.

The prospect of another three years of de facto minority government coming on the back of the minority Gillard/Rudd government over 2010-13 and the 2013-16 Coalition government’s inability to pass much of its economic and budget reform agenda through the Senate is not a good outcome for the Australian economy. Whoever wins it means that the risk of a sovereign credit rating downgrade has increased further.

More broadly, the success of Labor campaign offering more spending and higher taxes coming on the back of the Brexit outcome in the UK and the success of Trump and Sanders in the US adds to evidence that median voters are shifting to the left and away from the economic rationalist policies of deregulation, smaller government and globalisation. This is a negative for long term growth prospects and an additional constraint on investment returns.

Over the 8 weeks since the election was called Australian shares fell 0.6%. The next table shows that shares rose an average 4.8% over the 3 months after the last 12 Federal elections with 8 out of 12 seeing gains. Will we see a post-election rally over the next 3 months this time around? Relief at getting the election out of the way may help but the unclear outcome with the likelihood of minority government and the failure of the new government to have control of the Senate, September quarter seasonal weakness in shares and Brexit uncertainty are likely to weigh in the short term even though I see shares being higher by year end.

Major global economic events and implications

US economic data was good with a surprisingly solid increase in the June manufacturing conditions ISM index, good growth in consumer spending for the second month in a row in May, a rise in consumer confidence, continued gains in home prices, the June services PMI flat at 51.3 and continuing low jobless claims. While pending home sales and trade data were weaker than expected, March quarter GDP growth was revised up to 1.1% annualised and June quarter growth looks to have rebounded to around 3% annualised.

Eurozone economic sentiment fell only slightly in June and remains consistent with moderate growth and a pick-up in bank lending growth is a positive sign. Inflation rose slightly in June but remains low at 0.1% yoy for headline and 0.9% yoy for core.

Japanese jobs data for May remained strong, housing starts rose and the June quarter Tankan business conditions survey was little changed, but May data for household spending and industrial production were soft and core inflation slipped further to just 0.6% year on year adding to pressure for more stimulus.

Chinese business conditions PMIs for June were little changed consistent with growth running around 6.5% to 7%.

Australian economic events and implications

In Australia, early indications of the impact of the Brexit outcome on confidence suggest little impact with the ANZ/Roy Morgan weekly consumer sentiment reading falling just 1.7% to a level still above its long term average and auction clearance rates remaining solid. Meanwhile, job vacancies fell over the 3 months to May but on an annual basis still point to solid jobs growth, private credit growth slowed in May with credit to property investors continuing to lose momentum and business lending slowing, home price growth slowed in June with four capital cities seeing price declines but Sydney and Melbourne remaining strong, new home sales fell in May and the AIG’s manufacturing PMI improved to an okay 51.8.

What to watch over the next week?

The week ahead will no doubt see bouts of Brexit related nervousness but it may continue to settle down in the absence of any new developments in Europe. In Australia we will see reaction to the election result, but if it’s more of the same then the impact will be minor.

In the US, June payroll employment (Friday) is likely to bounce back by 180,000 jobs after the disappointing May gain of 38,000 with unemployment remaining at 4.7% and wages growth running around 2.6% year on year. But given the threat to confidence and growth from Brexit it won’t be enough to signal an imminent Fed rate hike in July. It will help ease fears regarding US growth though. Meanwhile, expect the non-manufacturing conditions ISM for July to remain around an ok 52.9 but the May trade deficit to deteriorate a bit given preliminary goods trade data (both Wednesday). The minutes from the last Fed meeting (also Wednesday) are likely to be very dovish but are dated given the Brexit outcome.

Chinese CPI inflation (Sunday July 10) for June is likely to have remained around 2% year on year but producer price deflation is likely to show a continued abatement.

In Australia, expect the RBA (Tuesday) to leave interest rates on hold for the second month in a row. Following its last meeting the RBA expressed a degree of comfort with current interest rate settings and while Brexit and Australian election related risks have added to the case for another rate cut at this stage the RBA is likely in wait and see mode. That said we still expect further easing this year with the August meeting providing a better opportunity to move as by then the risks flowing from Brexit and the Australian election will be clearer and we will have seen the June quarter inflation data.

In the meantime expect a sharp fall in May building approvals (Monday) after several months of strength and continued moderate growth in retail sales (Tuesday). ANZ job ads, the May trade deficit and the services PMI will also be released.

Outlook for markets

Brexit uncertainty and seasonal September quarter weakness could see more volatility in shares in the short term. The messy Australian election outcome is also likely to weigh on Australian shares in the short term. However, beyond near term uncertainties, we still see shares trending higher this year helped by relatively attractive valuations, very easy global monetary conditions and continuing moderate global economic growth.

Lower and lower bond yields point to a soft medium term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity, low inflation and ongoing shocks like Brexit. That said, the recent bond rally has taken bond yields to ridiculously low levels leaving them at risk of a sharp snapback at some point.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors.

Capital city dwelling price gains are expected to slow to around 3% over the year ahead, as the heat comes out of Sydney and Melbourne thanks to toughening lending standards and pockets of oversupply. Prices are likely to continue to fall in Perth and Darwin, but price growth may be picking up in Brisbane.

Cash and bank deposits offer poor returns.

The Australian dollar is still higher than it should be and the longer term downtrend looks likely to continue as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed eventually resumes hiking, the risk of a sovereign ratings downgrade continues to increase, commodity prices remain in a secular downswing and the $A sees its usual undershoot of fair value. The $A is still likely to fall to around $US0.60 in the years ahead.