Investment markets and key developments over the past week

Share markets were mixed over the last week, with US shares up 0.5% helped by good earnings news and Chinese shares up 0.7%, but Japanese down 0.1%, Eurozone shares down 2% on the back of a rising euro and Australian shares down 0.7% on the back of perceptions that the Reserve Bank of Australia (RBA) has become more hawkish. Bond yields fell. Oil prices fell but metals and iron ore rose, helped by further falls in the US$. This, along with perceptions of a more hawkish RBA helped push the A$ towards $US0.80, although this was dampened a bit by somewhat dovish comments by RBA Deputy Governor Guy Debelle.  

It's still too early to write off Trump's tax reform agenda. The failure of US Senate Republicans to agree on either a "repeal and replace" or "repeal and delay" of Obamacare obviously adds to uncertainty around whether Republicans in Congress can agree amongst themselves on a budget, government funding to avoid a shutdown in September, an increase in the debt ceiling which is necessary by early October and most importantly on tax reform. Of course health care reform could make yet another comeback, but uncertainty around all of these factors could cause bouts of angst in investment markets in the next few months. However, as we saw in 2013, it’s in neither of the major party's interest to allow a US government shutdown and neither party wants a debt default. More importantly though, while the risks around tax reform have increased, Republicans are in general agreement on wanting lower taxes, they need a win prior to next year's mid-term elections and after the mid-terms it’s unlikely they will be able to cut taxes because the Democrats are likely to have won control of at least the House of Representatives. So we still lean towards some sort of tax reform getting up. Interestingly though financial markets appear to have largely given up on it, but it hasn't stopped the US share market pushing new record highs.

The reported widening of special counsel Robert Mueller’s investigation to include President Trump’s business dealings adds to the risks around Trump, but we remain of the view that in the absence of clear evidence of criminal activity his own party won’t seek to impeach him, but after next year’s mid-terms the Democrats probably will, so it all just adds to the case for Republicans to get their business friendly reforms down now while they can.

Noise around a US trade war with Mexico and China is likely to pick up with the renegotiation of the North American Free Trade Agreement (NAFTA) coming up and signs of some deterioration in relations between the US and China and little progress in their Comprehensive Economic Dialogue. Time will tell, but the US' objectives for the NAFTA renegotiation suggest limited changes, US-China trade talks are continuing and we remain confident that despite lots of noise and partial moves (eg, US tariffs on steel imports) that cool heads will ultimately prevail.

Not another attempt to come the raw prawn with us on Australian interest rates! The financial market reaction to the minutes from the last RBA meeting was way over the top. Don't read too much into them.  I must admit to finding the periodic discordance between the post meeting statement and the minutes a bit disturbing - surely they relate to the same meeting and so should leave the same impression. It does make me wonder though whether the high level of RBA communications could just be adding to noise and confusion around interest rates at times. Mind you, this is a much bigger problem in the US. 

But back to where interest rates are headed...the minutes certainty did sound a bit more upbeat than the initial post meeting statement about growth and wages. But the bit that caused most excitement was the reference to a 3.5% neutral rate of interest, ie the rate of interest consistent with growth at potential, inflation at target and which neither causes the economy to accelerate or decelerate. Some have interpreted this as indicating that a series of eight quarterly rate hikes of 0.25% are imminent. This is very doubtful.

First, the neutral rate discussion looks to have been just a regular “deep dive” into a key issue and so as Deputy Governor Guy Debelle pointed out “no significance should be read into the fact the neutral rate was discussed” at the last meeting. 

Second, the neutral rate is a rubbery rather academic concept, a bit like the non-inflation accelerating rate of unemployment (NAIRU) and the “output gap”. In theory it should be around long run potential nominal growth, but it can move around a lot given attitudes to debt and debt levels, the gap between the rates bank lend at and the official cash rate, inflation expectations, uncertainty about what potential growth is, etc. At the Fed, they refer to a long term neutral rate (seen to be around 3% at present) and a short term neutral rate with Fed Chair Yellen recently saying it was already close to neutral with the Fed Funds rate at just 1-1.25%! So while a comparison to some neutral rate may be of use in assessing whether policy is easy or tight it’s not a firm target that central banks head for.

Third, for what it’s worth our assessment is that because of higher household debt to income levels and higher bank lending rate spreads the neutral rate is around 2.75%.

Fourth, a rise in the cash rate to 3.5% over the next two years if passed on in full would push the ratio of household interest payments to household disposable income from 8.6% currently to around 12%. This would be well above the average ratio of 9.6% since 2000, above the 2011 peak of 11.4% and towards the pre GFC peak of 13.2%, both of which saw hits to consumer spending – see the next chart. The hit this time would likely be greater as unlike a decade ago households lack the optimism to take on more debt to cover higher interest payments (remember the ATM in the lounge room!). So the 3.5% of income hit to spending power would likely take a big chunk out of consumer spending. Of course these numbers are averages - for those households with a mortgage the interest payment to income ratio would be around three times higher and in Sydney and Melbourne it would be even higher again. Which all suggests that in the absence of much stronger economic conditions rates won’t be increased by 2%.


 
Finally, heightened rate hike expectations have already pushed the A$ above $US0.79 and a cash rate of 3.5% would likely see it soar, exacting another round of damage on the economy just at a time when we still need a lower currency to offset the impact of still falling mining investment.

Reflecting all these influences, when it does come time to start raising rates the RBA won't be on autopilot on its way up to 3.5% but rather will be incremental, ie hike 0.25% and then wait to assess the impact. As we are seeing with the US Federal Reserve (Fed), the process is likely to be very gradual and we doubt that rates will be able to go as high as 3.5% any time soon as the RBA won't want to crash the economy. As to the timing of the first rate hike, while the RBA's upbeat view suggests the risk of an earlier move, our view remains that it won’t occur until late next year. While jobs growth and business confidence are good, other indicators are far more mixed - particularly around the consumer, wages and underlying inflation.

It’s worth noting that Deputy Governor Debelle also pointed out that: rate hikes by other central banks do not mean that the RBA has to raise rates too; interest rates in both the US and Canada remain below those in Australia; a rising A$ works against the benefit of stronger global growth; and that a lower A$ “would be helpful”. It’s hard to see any sign of an imminent RBA rate hike in any of this.

Major global economic events and implications

It was a bit of a quiet week on the data front in the US, but housing data was okay, with home builders’ conditions still strong, housing starts bouncing back and jobless claims remaining low. New York and Philadelphia regional manufacturing conditions surveys fell but remain strong. Meanwhile, its early days with only 96 S&P 500 companies reporting so far, but the June quarter earnings reporting season is off to a strong start with 81% exceeding earnings and 77% beating revenue expectations. Earnings are likely to have increased 10% over the year to the June quarter.

As expected, the European Central Bank (ECB) made no changes to monetary policy, sounding more upbeat on growth, but “not there yet” in terms of seeing inflation heading back to target. It still looks on track to announce a cutback later this year in its quantitative easing program to around €30bn a month for 2018 (from €60bn a month this year). I doubt this warrants recent euro strength though and if the euro continues to rise, it’s likely that the ECB will start to worry about its impact on growth and back off again. Meanwhile, the ECB's June quarter bank lending survey showed an ongoing improvement in the availability of credit and demand for it.

Again as expected, the Bank of Japan (BoJ) made no changes to monetary policy, having committed to continue quantitative easing and targeting a zero 10 year bond yield until inflation - which is currently around zero - reaches above 2%, which it doesn't now expect until 2019. The BoJ will remain a big laggard when it comes to monetary tightening resulting in a falling Yen.

Chinese data was solid across the board - with June quarter GDP growth holding at 6.9% year on year and industrial production and retail sales picking up. With growth stronger than expected there is a rising chance that the People's Bank of China will soon raise official interest rates. Don't expect an aggressive tightening though, as inflation remains benign.

Australian economic events and implications

Australian jobs data came in on the strong side again in June, with full time jobs again driving growth reversing the weakness seen up until a few months ago. If sustained, this should help cut into underemployment - but it's not clear that this is enough to drive stronger wages growth. Meanwhile, APRA's long awaited determination that Australia's big banks will need Tier 1 capital ratios of at least 10.5% by 2020 to be "unquestionably strong" saw banks rally sharply, as it was less onerous than feared and removes one source of uncertainty for the banks.

What to watch over the next week?

In the US, the focus will be on the Federal Reserve’s meeting on Wednesday, but given recent softness in inflation readings and in some data releases, it’s not likely to make any changes to monetary policy. However, it may flag again that an announcement to start letting its balance sheet run down will be made soon. We expect this to occur at its September meeting and continue to expect the next rate hike to come in December, albeit there is a risk that if inflation does not soon pick up it could be delayed into 2018. On the data front, June quarter GDP data (Friday) will be watched for a rebound after the seasonally weak March quarter. However, growth is only likely to have bounced back to around 2.5% annualised. Meanwhile, expect July business conditions PMIs to remain reasonably solid (Monday), home prices to show further gains but consumer confidence to fall slightly (albeit from very high levels) (both Tuesday) and decent gains in durable goods orders (Thursday). June quarter employment cost data (Friday) is expected to show that wages growth remains moderate. The US earnings reporting season will also ramp up, with over 100 S&P 500 companies reporting.

Eurozone business conditions PMIs will also be released Monday and economic confidence data will be released Friday and both are likely to remain strong.

Expect Japanese data to be released Friday to show continued labour market strength, some improvement in household spending but core inflation remaining around zero.

In Australia, June quarter inflation data and a speech by RBA Governor Lowe, both on Wednesday, will be watched for clues on the interest rate outlook. In terms of inflation, we expect consumer prices to have risen by 0.6% quarter on quarter or 2.4% year on year in the June quarter with a fall in petrol prices only partly offsetting higher vegetable prices on the back of Cyclone Debbie, an increase in tobacco excise and seasonal increases in prices for clothing and furnishings. Underlying inflation though is likely to be constrained by weak wages growth and come in at around 0.5% qoq and 1.8% yoy. As this is in line with RBA expectations it’s unlikely to alter the outlook for monetary policy. Governor Lowe's speech may provide more insight on this front and will be watched closely to see whether he reinforces the more hawkish impression given by the recently released minutes or seeks to lean against them, as Deputy Governor Debelle has done.

Outlook for markets

Shares remain vulnerable to a short term setback as we go through the weaker seasonal months out to October, with risks around Trump, North Korea, Chinese growth, the Fed and the Australian economy all providing potential triggers. However, with valuations remaining okay – particularly outside of the US, global monetary conditions remaining easy & profits improving on the back of stronger global growth, we continue to see the broad 6-12 month trend in shares remaining up. 

Low yields point to continuing low returns from sovereign bonds.  

Unlisted commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this will wane eventually as bond yields trend higher. 
National residential property price gains are expected to slow, as the heat comes out of Sydney and Melbourne. 

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.

The A$ has recently pushed higher helped by a combination of a generalised fall in the US$, some better Australian economic data and more upbeat comments from the RBA. The break of previous resistance around $US0.78 could see it push above $US0.80 in the short term. Our view however remains that the downtrend in the A$ from 2011 will ultimately resume as the interest rate differential in favour of Australia is likely to continue to narrow and will likely reach zero early next year (as the Fed hikes rates and the RBA holds) and commodity prices will also act as a drag.