Investment markets and key developments over the past week

Share markets have started 2017 on a broadly positive note, with economic data continuing to show an improving growth environment. US shares (+0.8%) were bolstered by strong US data prints and continued risk appetite. Australian shares (+0.4%) also had a good start to the year, echoing gains in the US and getting a boost from commodities. Solid Eurozone Purchasing Managers’ Index (PMI) data and signs of stronger inflation as an indicator of better growth prospects supported European shares (+0.4%). Japanese shares retreated (but this follows a surge on the first day of 2017 trading) as the Yen appreciated. The USD gave back some of its gains this week after the US Federal Reserve (Fed) meeting minutes talked down the currency, noting the risks posed by a higher US dollar which would ultimately limit the Fed’s ability to raise interest rates. US yields pulled back with the 10-year yield falling to 2.4% this week, after nearly reaching 2.6% in December 2016.

Shares experienced solid gains in the Santa Claus/New Year rally and are therefore now vulnerable to a pullback, particularly as investors consider the extent to which Trump’s policies can lift US growth and inflation in 2017. US economic data has notoriously disappointed in the first quarter of the calendar year as poor weather negatively affects growth and is not fully accounted for through seasonal adjustment. So far though, US data has been looking very positive. As well, China growth concerns could start mounting again as we go through the usual Lunar New Year seasonal slowdown.

The People’s Bank of China (PBoC) recently announced new measures to its exchange rate policies including a reweighting to its currency basket which added 11 new currencies, cutting the weighting of the US dollar. The PBoC also tightened rules around capital controls, to prevent the Chinese Yuan from depreciating further given recent USD gains, which caused some large gains in the yuan this week (+1.3%).

While there may be some near-term market jitters, there are numerous reasons to be optimistic on global growth in 2017:

  • There are very clear signs that world gross domestic product is lifting. Global PMIs have moved higher again after a soft patch in 2015-16. Our global PMI indicator is currently at its highest level since early 2014. Global growth of 3.2% looks likely in 2017, slightly higher than in 2016, with advanced economy growth around 2% while growth in China will probably be around 6.5%.
  • Headline inflation is lifting on better growth outcomes and higher commodity prices with core inflation rising more slowly.
  • The earnings recession looks to have ended – at least in the US and Australia with company forecasts suggesting that solid earnings growth is likely.
  • Monetary conditions will (overall) remain easy in the Eurozone and Japan with further easing likely in Australia which will support economic activity and growth assets.

Major global economic events and implication

Continued signs of improving US growth have been maintained in the early parts of 2017. In particular, business investment activity is looking better which is a critical component in the outlook for improving US growth. The December Markit manufacturing PMI was revised up to 54.3 and the manufacturing Institute for Supply Management index lifted to 54.7, the highest level since late 2014. The prices sub-index reading jumped significantly in December to 65.5 (from 54.5) – another sign of rising inflation. Construction spending in December rose again which is a good gauge for non-residential building growth.

December non-farm payrolls were up by 156K – a little below consensus, but the two prior months were revised up. The unemployment rate edged marginally higher to 4.7% as the participation rate stopped falling. Wages growth continues to pick up with average hourly earnings now running at 2.9% over the year. The employment data confirms that the US labour market is near full employment which will lift wages growth and inflation outcomes.

The December Federal Open Market Committee (FOMC) meeting minutes had a mildly hawkish slant, with “about half” of FOMC participant projections for economic growth being more positive based on more expansionary fiscal policy, partly counterbalanced by the impacts of higher interest rates and a stronger dollar. It was noted that there is plenty of uncertainty around what the timing, size and composition of potential fiscal spending would look like. The Fed is likely to wait a few months before lifting rates again, but another 2-3 rate hikes are still likely this year. The strength in the US dollar could be a factor that limits the extent to which the Fed can lift rates in 2017.

Japanese headline Consumer Price Index (CPI) is lifting (+0.5% year on year to December) but core inflation (which excludes fresh fruit and energy) is softer (+0.2% year on year to November down from 0.3% in October). At least inflation is no longer falling in Japan.

Chinese economic data showed a solid (14.5%) lift in industrial profits in November. Manufacturing activity continues to hold up with the official December manufacturing PMI at 51.4 (albeit marginally weaker compared to the prior month) while the non-official Caixin manufacturing PMI surged from 50.9 to 51.9 in December, the highest level in four years. Some moderation in PMI numbers may occur over the next few months as Chinese authorities place more emphasis on controlling financial risks and moderate fiscal spending.

Eurozone data showed a further upgrade to the December services PMI and German inflation was stronger than expected at 1.7% year on year to December.

In the UK, the December manufacturing and services PMI readings also had a very strong lift, continuing the run of better-than-expected post-Brexit data.

Australian economic events and implications

CoreLogic reported that dwelling prices increased by 0.9% in December and annual growth increased to 10.8%. In 2016, dwelling prices rose by 9.9% - the strongest calendar year of growth since 2009! The headline number masks a significant divergence across the nation, with Sydney and Melbourne price growth well above 10%pa, Perth prices declining and the other states recording more moderate growth. The brisk pace of dwelling price growth in 2016 would be a concern to the Reserve Bank of Australia (RBA), particularly given the implementation of policies to slow price growth and curb financial risks, including APRA macroprudential tools to target investor lending, out-of-cycle rate hikes for property investors and a tightening in bank lending standards. The RBA’s latest comments on the housing market noted that conditions in the established housing market had “strengthened” over the past few months which appear to be a bit relaxed, given the very high price gains in Sydney and Melbourne over 2016 and the impact on affordability.

Source: CoreLogic, AMP Capital

The RBA is relying on an increase in supply to drive housing prices lower which is likely to occur given the surge of new apartments coming into the market in 2017, particularly in NSW and Vic. But, the influx in new residential construction has been focussed to multi-story apartment buildings, rather than houses which means that the price correction may probably be more noticeable in the apartment sector, rather than in houses.

The November trade balance was a surplus for the first time since February 2014 as the impact of prior rises in commodity prices lifted export growth. Trade surpluses should continue for a few months given the gains in bulk commodity prices.

As well, leading indicators of activity are improving with the Performance of Services Index lifting in December to the highest result reading since May 2007 and the Performance of Manufacturing Index also increasing sizeably in December– a sign that the growth weakness in the third quarter of 2016 was only temporary?

What to watch over the next week?

In the US there are numerous Fed speeches, including from a few first-time voting members.

In Australia, the November building approvals should show a small rise, but the overall trend still remains down for residential approvals. Retail sales growth is likely to show a small rise after a few solid months. Job vacancies and job advertisements will be watched for any signs of labour market weakness.

The Chinese December CPI and PPI should show continued rises in prices and the trade data is also released.

Outlook for markets

Shares have experienced their traditional Santa Claus rally over the Christmas/New Year period. But, at some point in the first quarter a correction or consolidation in shares and the $US is likely as sentiment has become stretched on the upside. There will no doubt also be a nervousness post Trump’s inauguration around what the new US President will actually do, US-China tensions and the negative consequences domestically and globally of a higher $US. However, we see share markets trending higher over the next 12 months helped by ok valuations, continuing easy global monetary conditions, fiscal stimulus in the US, moderate economic growth and the shift from falling to rising profits for both the US and Australia.

Sovereign bonds are now very oversold and due for a short term pullback in yield which has already started happening in early 2017. But on a medium term view still low bond yields point to a poor return potential from bonds and the abatement of deflationary pressures as commodity prices head up, the gradual using up of spare capacity and a shift in policy focus from monetary to fiscal stimulus indicates that the long term decline in yields since the early 1980s is probably over. So expect the medium term trend in bond yields to be up.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors, but this demand will wane as bond yields trend higher over the medium term.

Dwelling price gains are expected to slow, as the heat comes out of Sydney and Melbourne and as apartment supply ramps up which is expected to drive 15-20% price falls for units in oversupplied areas into 2018.

Cash and bank deposits offer poor returns.

A shift in the interest rate differential in favour of the US as the Fed remains on its path to hike rates should see the long term trend in the $A remain down.