Investment markets and key developments over the past week
Share markets were mixed over the last week, with US shares down 1% on the back of a some soft US earnings reports and nervousness ahead of a likely US Federal Reserve (Fed) rate hike in December, Australian shares down 0.6%, but Japanese shares basically flat, Eurozone shares up 0.8% and Chinese shares up 1.6%. Bond yields rose, oil prices rose but metal prices fell, and the A$ rose despite a stronger US$.
Seven reasons why a Fed rate hike in December and the $US breaking higher are unlikely to cause a re-run of the market scare we saw late last year/early this year: (The US money market is now pricing in a 66% probability of a December Fed rate hike and this is putting renewed upwards-pressure on the value of the US$ and on bond yields, with the latter weighing on defensive high yield share market sectors like REITs and listed infrastructure. While this could contribute to a corrective pull back in shares in the short term, a return to the turmoil seen through the second half of last year and into early this year is unlikely.)
- First, the global growth outlook is a bit more positive now.
- Second, there is now a greater level of understanding and confidence that the Chinese Renminbi is not going to crash, as the Chinese are targeting a relatively stable trade weighted level for the Renminbi and capital outflows from China have not accelerated.
- Third, last year poor supply/demand dynamics and a rising US$ were causing a double whammy for commodity prices, which in turn was weighing on commodity producers, whereas now commodity prices appear to have bottomed. This in turn is adding to confidence that the profit recession in both the US and Australia has likely ended.
- Fourth, worries about a US$ funding-crisis in the emerging world have receded, as commodity prices have stabilised and emerging market growth is looking a bit healthier.
- Fifth, the back-up in bond yields is likely to remain gradual as global growth remains subdued, the Fed will likely remain gradual in hiking rates and any handover from monetary to fiscal policy in will also be gradual.
- Sixth, the Fed has made it clear that it is aware of the impact of US rate hikes globally and that a stronger US$ does part of its job for it, so there should now be greater confidence that it won't just blindly hike interest rates to the point that it threatens US/global growth.
- Finally, while defensive yield share market sectors may see more downside, cyclical share market sectors are likely to strengthen with this rotation already evident.
From worries about a Trump presidency to worries about a Clinton/Democrat clean sweep. With the Trump campaign falling into disarray again as his fitness for presidency is once again called into question, there is now an increasing risk that a backlash against Republicans could see them lose not just their Senate majority but also control of the House of Representatives. Such a scenario would worry investors to the extent that it would make it easier for less business friendly tax and regulation policies to be put in place that might weigh on health, energy and financial companies. The polls are clearly moving in Clinton's favour again, but it’s doubtful that it’s enough to generate a wave of support strong enough to see the Democrats take both houses of Congress. While there is a good chance the Democrats will gain a majority in the Senate (but not necessarily the 60 seat control) it’s hard to see them winning the 30 seats necessary to control the House. Current polling suggests they will pick up only around 10 seats. Sure, Obama's victory in 2008 saw a Democrat clean sweep, but back then the Democrats already had small minorities in both houses of Congress which they built on whereas this time around they are starting well behind and don't have the GFC to help them. So while the probability of Clinton becoming president has gone up (from around 55% a few weeks ago to now¬ around 70%), a Democrat clean sweep is possible but I would only raise the probability of it occurring from 5% to 10%. History shows that the best combination for shares is a Democrat president and a Republican House.
Finally, there is more good news on the commodity price front for Australia, with the more than doubling in average coal prices flowing through to coal contract negotiations with Japan. While coal prices may not ultimately settle at current high levels, they do look to have bottomed, which is another sign that the terms of trade and national income may have seen the worst pass. Higher bulk commodity prices, if sustained, will also see a big improvement in the Federal budget deficit and could eliminate the trade deficit. Given this, along with reasonable economic growth and the rising prospect of a December Fed rate hike taking upwards pressure off the $A, the probability of a November Reserve Bank of Australia (RBA) rate cut is rapidly collapsing.
Major global economic events and implication
The minutes from the Fed's last meeting reinforced the impression that they are on track to hike rates in December. But by the same token, the minutes were not really hawkish, with ongoing reference to "few signs of emerging inflation pressures". Dovish comments by Fed Chair Yellen regarding the case to let the economy run hot for a while to help fix damage caused by the GFC add to the impression that the Fed expects to remain gradual in raising rates. US data releases were mixed, with a stronger than expected rise in producer price inflation and headline retail sales, but underlying retail sales growth remaining soft, consumer sentiment down, a slight fall in small business optimism and mixed readings on the jobs market. Its early days in the September quarter earnings reporting season with only 34 S&P 500 companies reporting so far, but while Alcoa kicked off with a disappointment, 79% of companies have so far surprised on the upside.
Chinese export and import data for September were weaker than expected, after several months of improvement. It’s a bit too early to tell whether this is a concern. In other activity, data power consumption slowed to 6.9% year on year in September, but auto sales rose 26% yoy. Meanwhile, consumer price inflation picked up to 1.9% yoy (mainly due to higher food prices) and producer prices rose 0.1% yoy, their first rise in over four years. The improvement in producer price inflation is suggestive of stronger nominal growth in China and consistent with global deflationary pressures receding.
Australian economic events and implications
Both consumer and business confidence are now above long term average levels, which is consistent with ongoing reasonable economic growth. Meanwhile housing finance was soft, which contrasts with strong auction clearances, but it’s noteworthy that while auction clearances are high, it is on falling volumes so maybe they a not as strong as they appear.
The RBA’s Financial Stability Review indicated some lessening in concern regarding household debt, as lending standards have strengthened, but it does appear to be increasingly (& understandably) concerned around the risks flowing from large increases in the supply of apartments. Overall it sees Australian banks remaining resilient to shocks.
What to watch over the next week?
In the US, the focus is likely to remain on the election, with the final presidential debate on Wednesday, consumer price inflation data will likely remain consistent with a December Fed rate hike and September quarter earnings reports will start to flow in earnest. On the data front in the US, expect to see a partial bounce back in September industrial production (Monday), a further rise in CPI inflation (Tuesday) to 1.5% yoy as the plunge in the oil price drops out, but core inflation remaining around 2.3% yoy, continued strength in home builder conditions (also Tuesday) and gains in housing starts (Wednesday) and existing home sales (Thursday). Manufacturing conditions surveys for the New York and Philadelphia regions will also be released along with the Fed’s Beige Book of anecdotal evidence on the economy.
In Europe, the focus will be on the European Central Bank (ECB) meeting (Thursday) but no change in policy is likely. A decision on extending its quantitative easing program beyond its March 2017 expiry is unlikely until the December meeting. Inflation is below target but with growth okay and the current program still having a while to run, there is no reason for the ECB to decide now.
Chinese economic data is expected to remain consistent with a stabilisation in growth. September quarter GDP growth is expected to be unchanged at 6.7% yoy and September data is expected to show a slight pick-up: in industrial production to 6.4% yoy (from 6.3%), in retail sales to 10.7% (from 10.6%) and for fixed asset investment to 8.2% (from 8.1%).
In Australia the minutes from the last RBA Board meeting and a speech by Governor Lowe (both Tuesday) will be watched for any clues regarding the outlook for interest rates, but they are likely to reinforce the impression that the RBA is comfortably on hold for now. On the data front expect a 20,000 gain in employment for September but the unemployment rate to rise back to 5.7% from 5.6%.
Outlook for markets
October is often a rough month for shares and we remain cautious on them in the short term as event risk is high for the months ahead, including ongoing debate around the Fed and ECB, issues around Eurozone banks, the US election on November 8 and the Italian Senate referendum & Austrian presidential election re-run (both on December 4). However, after any short term weakness, we anticipate shares to trend higher over the next 12 months helped by okay valuations, continuing easy global monetary conditions and moderate global economic growth.
Ultra-low bond yields point to a soft medium term return potential from them, but it’s hard to get too bearish on bonds in a world of fragile growth, spare capacity, low inflation and ongoing shocks.
Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors.
Dwelling price gains are expected to slow, as the heat comes out of Sydney and Melbourne thanks to poor affordability, tougher lending standards and as apartment supply ramps up which is expected to drive 15-20% price falls for units in oversupplied areas around 2018.
Cash and bank deposits offer poor returns.
Increasing confidence that the Fed will hike rates again by year end has taken some pressure off the A$ in the short term and we continue to see the longer term trend remaining down as the interest rate differential in favour of Australia narrows as the RBA continues cutting rates and the Fed eventually resumes hiking, commodity prices remain low and the A$ sees its usual undershoot of fair value.