Investment markets and key developments over the past week
Wariness returned to investment markets in the past week led in part by worries about Italian banks but this was reversed to some degree on Friday by strong US jobs data. As a result share markets were mixed over the week with Eurozone shares down 1.6%, Japanese shares down 3.7% (not helped by the rising Yen) and Australian shares down 0.3% but US shares rose 1.3% (to around a record high) and Chinese shares rose 1.2%. Worries about Australian banks - on the back of global bank weakness, APRA indications that further capital raising may be required and the shift in Australia's and banks' credit rating outlook to "negative" by Standard and Poors - weighed on the Australian share market. Bond yields continued to fall and a rising $US weighed on oil and metal prices and saw the Chinese Renminbi fall to its lowest level since 2010. Despite the rising $US and S&P placing Australia's credit rating on negative outlook, the $A rose.
Fears around a recession in the UK following the Brexit decision continue to build with business confidence falling sharply. Clearly UK business is concerned about their continued access to EU markets. These concerns have also hit the UK commercial property market with several unlisted property funds halting redemptions as investors anticipate a bleak outlook for the UK property market if businesses decide to relocate operations to Europe. While the Bank of England cut banks' capital requirements and the continuing plunge in the value of the British pound should help, it's doubtful this will be enough to stop a recession later this year. Bear in mind though that the UK economy is only 2.5% of global GDP. It's also worth noting that the problems with British property funds are reflective of a specific problem in the UK post Brexit. It's not indicative of a problem with global commercial property markets generally.
But will Brexit even happen? Given the Bregret and mayhem in the UK there is some chance that Article 50 of the Lisbon treaty, which governs exits from the EU will never be triggered. This could happen say if the new conservative leader waits till next year to trigger Article 50 by which time a recession could have moved popular opinion against Brexit or alternatively if a new election is called which becomes another defacto referendum on Brexit. It's also possible that the UK does trigger Article 50, but then in negotiating with the rest of the EU concludes it doesn't want to go. While once triggered Article 50 supposedly means no going back it's likely that in this circumstance the EU will find a way to keep the UK in. All of this has a long way to play out though. Of course, the real issue for the global economy and investment markets is the impact on Europe and the risk of a domino effect of exiting Eurozone countries. But if Britain ultimately doesn't leave or leaving is demonstrated to be more trouble than remaining then the risk of a domino effect will be much reduced.
But back to the present, in the Eurozone the main focus regarding post Brexit risks in the past week relates to European - mostly Italian - banks. These have been weakened by years of slow growth, ultra-low interest rates and tighter regulatory conditions. These risks preceded Brexit but the Brexit scare has refocused attention on them by pushing down bank share prices which in turn makes it harder for banks to raise capital. Italian banks are arguably most at risk with the Italian government wanting to recapitalise some of them, but the European Commission preferring a bail-in from creditors. Not recapitalising them risks slower bank lending, slower growth and higher unemployment and hence a greater risk of support for a move out of the Eurozone in countries like Italy. At this stage we are a long way from this and some sort of muddle through solution will likely be found. But of course it won't stop investors worrying about it in the interim.
On the positive side of the equation its notable that Italian and Spanish bond yields remain around record lows, suggesting the threat of ECB intervention is working, the latest rise in the value of the $US and associated fall in the Chinese Renminbi has not been associated with the panic around capital outflows from China that we saw earlier this year, and commodity prices continue to hold up reasonably well which may be a good sign for global growth. But again its early days yet and one risk worth keeping an eye on is that of a further rise in the $US. Ongoing upwards pressure on the $US is a real risk given the risk of safe haven flows out of Europe at the same time that the US economy looks to be doing okay as confirmed by strong June employment gains which suggests a much greater chance of a Fed hike this year than the 21% probability that the US money market is assigning. Another break higher in the $US would be bad for oil and other commodities, the emerging world and the Chinese Renminbi.
In Australia, while counting continues following the Federal election (why does it take so long?) Bill Shorten has conceded defeat and Malcolm Turnbull has claimed victory as it's clear that the Coalition will be able to govern either as a majority government or as a minority government with independents like Bob Katter. The issue of course is that the Senate is likely to be less friendly than over the last three years which will mean that a Coalition Government will have little chance of passing key aspects of this year’s Federal Budget including its company tax cuts (at least not for large companies), some of its superannuation changes and the still to be passed savings from the 2014 budget. The likelihood would be more slippage in the return to budget surplus. Serious economic reform looks off the agenda. The good news is that there has been talk of finding "common ground" - let's hope!
Reflecting the risk of yet more budget slippage its little surprise to see the ratings agencies getting tetchy, with Standard and Poors putting Australia’s sovereign rating on negative outlook. This of course does not mean a downgrade is inevitable but with the new parliament “unlikely to legislate savings or revenue measures sufficient….for the budget deficit to narrow materially” [in the words of S&P] I would say that it’s probable. So far the financial markets have taken the move to negative outlook calmly perhaps because it has long been talked about. In theory a ratings downgrade should mean higher interest rates as foreigners demand a higher yield on Federal debt and this flows through to state debt, banks, corporates and potentially to out of cycle mortgage rate hikes for households. In reality this impact may be muted. The US in 2011 and the UK last week actually saw bond yields fall after ratings downgrades and many lower rated countries borrow more cheaply than Australia (e.g., Italy and Spain). And in any case the RBA can still offset higher mortgage rates with another interest rate cut.
Rather the biggest concern about the threat to our AAA rating is what it tells us about policy making in Australia today. Australia worked hard reforming the economy after last being downgraded in 1986 and won a AAA rating back in 2002. Losing it again would signal we have become unable to control public spending, that we have lost our way to some degree after the hard work of the Hawke/Keating & Howard/Costello years.
Major global economic events and implications
US economic data was good with a very strong rebound in June payroll employment, continuing low jobless claims and the ISM non-manufacturing index rising to a solid 56.5 in June. The June payroll employment gain of 287,000 more than makes up for the weak May gain. Abstracting from monthly noise, jobs growth averaged a solid 147,000 a month over the last three months telling us that the US economy is doing well. The Fed will probably still want to see more evidence that US growth has picked up sustainably and that global risks post-Brexit are settling down and so won’t be rushing to raise rates soon, particularly with wages growth remaining low. However, given the solid June payroll report we remain of the view that the Fed will raise rates again this year, probably in December. The US money markets’ assessment of just a 21% chance of a Fed hike this year (up from 12% pre payrolls) is way too pessimistic and will likely move up, which in turn will place upwards pressure on bond yields at some point by year end.
Japan’s poor PMI readings, falling wages and a 20% rise in the Yen since last year’s high add to pressure on the BoJ. Expect BoJ easing and intervention to push the Yen down soon.
Australian economic events and implications
In Australia, the RBA opened the door to another rate cut indicating that it was awaiting “further information” which is presumably a reference to June quarter inflation data later this month. We remain of the view that the RBA will cut rates again as the risks to inflation are on the downside, the risks to growth are on the downside (with Brexit and the messy Australian election not helping) and the $A is still too high. We are allowing for two more 0.25% rate cuts this year, the first in August.
Australian data was on the soft side with a fall in building approvals and slowing momentum in retail sales but ANZ job ads still pointing to reasonable jobs growth.
What to watch over the next week?
In the US, expect a modest gain in June retail sales, a slight improvement in industrial production and core CPI inflation around 2.2% year on year (all Friday). Alcoa will kick off June quarter earnings reports on Monday. The consensus sees a 5% decline in earnings yoy, but this will mark a rise on the March quarter, with a more stable $US and oil price helping.
Expect the Bank of England to ease monetary policy Thursday.
In China, June quarter GDP is likely to show a softening in growth to 6.6% year from 6.7% (Friday)However, the quarterly rate of growth is expected to rise. Data for industrial production, retail sales & investment may show a slight slowing.
In Australia, expect a fall in housing finance (Monday), little change in business conditions in the June NAB business survey (Tuesday), a small fall in consumer confidence (Wednesday) on the back of Brexit and election noise and a 10,000 gain in jobs but a slight rise in unemployment to 5.8% (Thursday).
Outlook for markets
Brexit uncertainty, Italian bank risks, renewed $US strength and seasonal September quarter weakness could see more volatility in shares in the short term. However, beyond near term uncertainties, we still see shares trending higher this year helped by okay 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. Renewed expectations for Fed tightening may be the driver.
Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors.
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 apartment prices get hit by 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 continueas 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.