Investment markets and key developments over the past week
The past week saw shares rise 0.9% in the US, 1.5% in China and 0.3% in Japan helped by more good economic data, but Eurozone shares fell 0.3% and Australian shares lost 1.2% as profit results became more mixed towards the end of the profit reporting season. Bond yields generally fell and commodity prices were mostly up. The A$ was little changed.
While shares have generally continued to push higher they remain at risk of a short term correction being technically overbought again and with short term investor sentiment at levels often associated with corrections. A major misstep on economic issues by President Trump, worries about Eurozone politics, policy tightening in China or signs of faster Fed rate hikes could all be a trigger. Trying to time this remains difficult though and we just see it as a correction (say with a 5% decline) rather than something more severe with the profit outlook (both globally and in Australia) continuing to improve.
Business conditions PMIs remain strong in February with Europe and Japan up but the US down slightly albeit remaining strong. This is good news for a continuation of the global profit recovery going forward, with profits needed to take over as a key driver of the bull market in shares as these are no longer dirt cheap or under loved.
Eurozone break up risks continued to remain a focus over the last week with the risks easing a bit around the French election (as the prospects of combined Socialist/far left presidential bid receded, an investigation around Marine Le Pen's use of European Union funds hotted up and centre left candidate Emmanuel Macron and another centrist candidate agreed to work together); Greece edging towards a deal with the IMF and EU on its latest bailout review; but the risks around a break-up of the governing Democratic Party in Italy remaining. There is a long way to go on the Eurozone break up risk soap opera so lots could go wrong (including more rioting in French suburbs boosting support for Marine Le Pen) , but a break up still seems far from imminent so spikes in fears around Europe should be seen as buying opportunities. Particularly with Eurozone shares still clearly cheap and underlying economic conditions in Europe looking good.
On the interest rate front in Australia, a speech and Parliamentary testimony by RBA Governor Philip Lowe has reiterated that the RBA is trying to balance the risks of inflation staying lower for longer versus the threat to financial stability that may flow from ever higher household debt if the RBA cuts rates again. Governor Lowe is clearly happy with another “period of stability” in rates and in other words is prepared to run a higher risk in terms of inflation remaining lower for longer to head off the risk of higher household debt. Fair enough. As this points to a relatively high hurdle to cutting rates again – eg, worsening unemployment or a further leg down in inflation – the risk that we may not get the rate cut we have been looking for is high.
Two reasons why allowing first home buyers in Australia to access their super to buy a house is a really dumb idea. First, any boost in their home buying power will just be reflected in even higher home prices (as with first home buyer grants and lower interest rates). Second, it will mean they have less money for retirement as their lower super balances in the early years of their working lives will mean less for compound interest to work its magic on. So even less affordable housing and less in retirement. This idea gets floated every few years but its best forgotten.
Major global economic events and implication
The key message from the minutes from the Fed's last meeting was that the Fed is on track to raise interest rates again "fairly soon" providing economic data is in line with or better than their expectations. Of course the term "fairly soon" is a bit vague and could mean any of its March, May or June meetings. Since the last Fed meeting though strong payrolls data and CPI inflation suggest a risk of a March move but slow wages growth and a desire to remain consistent with three hikes this year point to a move around May or June. This is our base case but we see a 40% chance of a March hike. Meanwhile, data over the last week added nothing new with business conditions PMIs falling slightly in February but remaining strong, home sales rising strongly, home prices continuing to rise, consumer sentiment remaining strong and jobless claims remaining low.
Eurozone business conditions PMIs - both manufacturing and services - improved further in February pointing to acceleration in growth. For now the ECB is committed to quantitative easing through to the end of the year at the rate of €60bn a month, but debate about when it will announce a taper will likely to continue to hot up. Nothing is likely to be announced till later this year though, at least not until after the French election is out of the way.
Japan's manufacturing conditions PMI also improved further in February continuing a recovery since May last year and pointing to stronger growth ahead.
Australian economic events and implications
The news on the Australian economy over the last week was on balance a little bit disappointing with wages growth remaining at a record low and investment coming in weaker than expected. Low wages growth adds to the risk that inflation will stay lower for longer and soft business investment data will constrain the expected rebound in December quarter GDP growth after the September quarter contraction. However, while investment plans for the financial year ahead are yet again below those of a year ago the rate of decline has slowed (see the next chart) and its all driven by mining investment (which is falling at the rate of around 30% pa) whereas plans for non-mining investment are about 7% stronger than was the case a year ago. What's more, the drag on overall growth in the economy from the mining investment slump is diminishing as it’s now a much smaller share of the economy and in any case it's getting back to levels that are close to as low as it ever goes.
Source: ABS, AMP Capital
Cuts to penalty rates – good or bad? The Fair Work Commission’s decision to cut Sunday and public holiday penalty rates by 25% or so has created much contention. But it basically comes down to a trade-off between wages for those in relevant industries with jobs and the 1.8 million people without jobs or who are underemployed. Yes it will cut wage income for those affected and will weigh further on average wages growth, but against this the decision partly reflects the fact that Sundays and public holidays are no longer sacrosanct like they used to be and it will make it possible for employers to employ more people or have them for longer hours (unless you believe that demand for something goes down when its price goes down). So the decision is no disaster for the economy and if anything by injecting a bit more flexibility into the labour market will help boost productivity and employment. It also maintains the hope that Australia can still get through a bit of economic reform, despite the scare campaign around any proposed economic reforms that dominates the media 24/7 now.
The Australian December half profit reporting season is now just over 90% done. Results remain consistent with a strong return to profit growth but as always we have seen more soft results as the reporting season has progressed. 46% of companies have exceeded earnings expectations compared to a norm of 44%, 59% of companies have seen profits up from a year ago and 59% have increased their dividends from a year ago. But reflecting the strong rally in the market ahead of the results only 50% of companies have seen their share price outperform the market on the day they reported as a lot of good news was already priced in. Consensus profit expectations for the overall market for this financial year have been revised up by around 2% through the reporting season to a strong 19%. This upgrade has all been driven by resources companies which are on track for a rise in profit of 150% this financial year reflecting the benefits of higher commodity prices and volumes on a tighter cost base. Profit growth across the rest of the market is likely to be around 5% with mixed bank results and constrained revenue growth for industrials. Outlook comments have generally been positive and as a result the proportion of companies seeing earnings upgrades has been greater than normal. The focus has remained on dividends with 79% raising or maintaining their dividends.
Source: AMP Capital
Source: AMP Capital
Source: AMP Capital
What to watch over the next week?
In the US, President Trump’s address to Congress on Tuesday will be watched for details around his plans for tax cuts, infrastructure spending, etc. The focus will also be on the February ISM manufacturing index (Wednesday) and non-manufacturing conditions index (Friday) both of which are likely to remain strong and speeches by Fed Chair Yellen and Vice-Chair Fischer (Friday) which will be watched for clues as to whether to expect faster Fed rate hikes. Meanwhile, expect underlying durable goods orders to show further improvement and a rise in pending home sales (both Monday), a slight upwards revision to December quarter GDP growth to 2.1% annualised and continued strength in home prices and consumer confidence (all Tuesday) and a rise in inflation as measured by the core private final consumption deflator (Wednesday) to 1.8% year on year from 1.7% previously.
In the Eurozone, expect economic confidence indicators for February (Monday) to have remained strong, CPI inflation to edge a bit higher but core inflation to have remained around 0.9% yoy and unemployment (Thursday) to have fallen to 9.5%.
In Japan, expect a slight pull back in January industrial production (Monday), but continued strength in labour market indicators and a slight further improvement in household spending (Friday). Core inflation (also Friday) is likely to have remained around zero.
Chinese manufacturing conditions PMIs for February (Wednesday) are expected to have remained around 51.
In Australia, December quarter GDP data is likely to show a bounce back in growth led by a stronger consumer, a rebound in dwelling investment and public spending, better trade volumes and a bit less negative business investment. However, it looks likely to be only around 0.6% qoq leaving annual growth at just 1.8% yoy. Ahead of the GDP release expect a strong rise in December quarter company profits led by the mining sector (Monday) and net exports (Tuesday) to contribute 0.2 percentage points to GDP growth. Meanwhile expect continued momentum in February home prices (Wednesday), another big trade surplus (Thursday) and a small fall in building approvals (Thursday).
The Australian December half profit reporting season will wrap up on Monday and Tuesday with only 15 major companies left to report including QBE Insurance and Lend Lease.
Outlook for markets
Shares remain vulnerable to a pull back as short-term investor sentiment towards them is very bullish, Trump-related uncertainty will be with us for a while and various European elections could create nervousness in coming months. However, we see share markets trending higher over the next 12 months helped by okay valuations, continuing easy global monetary conditions, fiscal stimulus in the US, some acceleration in global growth and rising profits.
Still low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds. Australian bonds are preferred to global bonds, reflecting higher yields and the RBA being well behind the Fed in raising rates.
Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this demand will wane as bond yields trend higher over the medium term.
National residential property price gains are expected to slow to around 3% to 4% this year, as the heat comes out of Sydney and Melbourne and rising apartment supply hits.
Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.
The A$ has had a short term bounce as the US$ corrected from overbought levels. This could go further and see a retest of US$0.78 which if broken would likely see a run up to US$0.80. However, the downtrend in the A$ from 2011 is likely to resume at some point this year as the interest rate differential in favour of Australia narrows and it undertakes its usual undershoot of fair value.