Investment markets and key developments over the past week
While the last week saw US shares gain 0.6% to a new record high, European shares rise 2.9% and Japanese shares gain 1.3% helped by good economic and earnings news, anticipation of a good outcome from the French election and a weaker Yen, Chinese shares lost 1.7% and Australian shares fell 1.5% on the back of signs of softer growth in China. A 10% fall in the iron ore price particularly weighed on Australian resources stocks. Bond yields mostly rose, but commodity prices fell and this weighed on the Australian dollar which looks to be breaking down again.
In the US, the Federal Reserve provided no real surprises describing the March quarter growth slowdown as transitory, remaining confident on the economic outlook and still foreshadowing gradual rate hikes contingent on the economy evolving as it expects. A solid 211,000 rise in April payroll employment and a fall in unemployment to 4.4% supports the Federal Reserve’s confidence in the US growth outlook but a slight fall in wages growth to just 2.5% year on year will keep the monetary tightening process very gradual. Our view remains that it is on track to hike rates again at its June meeting (with the money market factoring in a 100% probability) and again in September and will then start allowing its balance sheet to decline later this year.
Continuing in the US, while President Trump indicated that he was thinking about raising gasoline tax to fund infrastructure and break up the banks into banking and trading arms, both are unlikely as there is little support in Congress. Elsewhere there was good news on the policy progress front with a government shutdown avoided (at least until September) and the House of Representatives passing an Obamacare reform bill. The latter still has to pass the Senate but it augurs well for tax reform being passed later this year or early next.
Emmanuel Macron has won the French presidential election against the far right, anti-globalisation, anti-euro National Front candidate Marine Le Pen. With all the talk about a populist/nationalist surge across Europe the surprise for many may have been that Le Pen did not do better. Support for nationalists in Europe and a break-up of the Euro has been wildly exaggerated since the Brexit vote and the outcome of the French presidential election is the fourth election since Brexit - Spain, Austria, the Netherlands and now France - that has seen the nationalists do far less well than the headlines initially suggested.
Macron's policies seek to strengthen the European Union and the Eurozone and maintain openness and are mildly reformist for France focussing on labour market deregulation, lower taxes and a reduced role for the state - which would be good for the Euro and the French economy. That France has opted for this path - albeit with not whole hearted support (then again only just over a third of eligible British voters voted for Brexit!) - and rejected the nationalist divisive politics of the National Front is a very good sign.
As such the result is positive for investment markets, particularly French and Eurozone shares and the Euro. However, with French shares already up 7.4% and Eurozone shares up 6.3% since the first round election and the Euro up against technical resistance after recent strong gains much has already been factored in.
The focus will now shift to June 11 and 18 parliamentary elections in France where polls point to a poor showing by the National Front but Macron’s En Marche! (Onwards) potentially winning a majority or able to form a reformist government probably with support from centre-right Republicans.
While some see the German election in September as a threat this is very unlikely as the contest looks to be between Angela Merkel and the Social Democrats under Martin Schulz who are even more pro Europe, with the nationalist Alternative for Deutschland polling less than 10%. As such, the German election should further help reduce Eurozone break up fears. While Italy remains a risk for next year, this all comes at a time when Eurozone assets remain relatively cheap globally and Eurozone economic data continues to improve. All of which is consistent with retaining a large exposure to Eurozone shares.
Major global economic events and implications
US economic data over the last week remained consistent with reasonable growth ahead. While auto sales in April were softer than expected and manufacturing conditions slowed a bit according to the Institute for Supply Management index, its nonmanufacturing conditions index rose, the trade deficit was better than expected and jobs data was solid. March quarter profits continue to impress investors with 78% of companies exceeding earnings expectations, 65% exceeding sales expectations and profits up around 14% year-on-year.
Eurozone GDP growth was solid in the March quarter and December quarter growth was revised up with business conditions indicators pointing to a further improvement ahead. Unemployment was unchanged at 9.5% in March, which is well down from its 2013 high of 12.1%. Eurozone March quarter profits are running at a 24% level of increase year-on-year.
China’s official and Caixin business conditions Purchasing Managers’ Index slipped in April consistent with the view that recent policy tightening has impacted, that the upswing in growth momentum is likely now over and that growth this year will be constrained around 6.5%.
Australian economic events and implications
In Australia, the Reserve Bank of Australia left interest rates on hold and its Statement on Monetary Policy made no significant changes to its economic forecasts, but it’s more confident that its forecasts for stronger growth and inflation are on track. With the economy growing, headline inflation back within the Reserve Bank of Australia’s 2% - 3% target zone and concerns remaining around the Sydney and Melbourne property markets, the pressure to cut rates again has declined. But by the same token it’s too early for the Reserve Bank of Australia to think about raising rates given continuing low underlying inflation pressure, very high underemployment, record low wages growth, risks to growth from weaker than expected trade volumes and a still too high Australian dollar. Signs that Sydney and Melbourne property markets may be starting to cool – thanks to bank rate hikes, tightening lending conditions, all the talk about a property bubble and rising unit supply – will if continued, add to the Reserve Bank of Australia’s flexibility on rates. While Governor Lowe has stated that “over time we could expect interest rates to rise” this is really just a statement of the obvious. Our base case remains that the Reserve Bank of Australia will be on hold out to the second half of 2018 when rates will start to rise.ntum is likely now over and that growth this year will be constrained around 6.5%.
On household debt and house prices Governor Lowe provided a good analysis of the Reserve Bank of Australia’s concerns about why high household debt to income ratios leave the economy vulnerable – the risk being that at some point households decide that they have borrowed too much and that they should reduce their debt levels which would adversely affect spending and hence magnify any economic impact from a shock to income or house prices. This is a valid concern and our view remains that the intersection of high house prices and household debt are Australia’s Achilles heel. As always it’s hard to see the trigger for such a shock but the ideal outcome remains an extended period of flat/range bound home prices allowing incomes to catch up. Governor Lowe also pointed out that the Reserve Bank of Australia will take account of the likely greater responsiveness of consumer spending to interest rate hikes – expect the next interest rate tightening cycle to be even more gradual and modest than those of the past.
In terms of the housing market while auction clearance rates remains very strong, CoreLogic home price data showed a slowing in Sydney and Melbourne in April with falling prices for units suggesting that these two property markets may be starting to cool.It’s too early to get too excited though given the impact of school holidays, Easter and Anzac Day in April. Meanwhile the AIG manufacturing and services conditions Purchasing Managers Index data for April were strong pointing to solid economic growth. However the trade surplus fell in March thanks to stronger imports and the impact of Cyclone Debbie on coal exports which will be more noticeable in April. Expect net exports to again detract from growth in the March quarter, resulting in a weak GDP growth outcome.
What to watch over the next week?
The outcome of the French election will likely dominate early in the week. In the US expect small business confidence to pull back a bit and continued strength in labour market indicators (both Tuesday), a bounce back in consumer price inflation but with the annual core rate remaining around 2% and strong gains in April retail sales (both Friday).
Chinese trade data is expected to show slightly slower but still strong export and import growth (Monday) of 10% and 15% respectively, consumer price inflation (Wednesday) is likely to rise to 1.1% year-on-year but producer price inflation should fall back to 6.8% as commodity price momentum wanes.
In Australia the main focus will be on the 2017-18 Federal budget on Tuesday. This budget won’t have the divisive austerity focus of the 2014-15 budget nor the pre-election and superannuation focus of last year’s budget. The attention is likely to be on three areas: the budget deficit projections, a ramp up in infrastructure spending and housing affordability.
First, after years of budget deficit blow outs thanks to optimistic economic assumptions, spending blow outs and a failure to pass budget savings, this Budget could see a slight improvement in the deficit projections relative to December’s mid-year review.While low wage growth is dragging on personal tax collections, higher corporate tax collections thanks mainly to higher iron ore and coal prices will likely provide some offset. The Budget is likely to forecast 2017-18 real GDP growth of 3%, nominal GDP growth of 4% and unemployment of 5.5%. We expect the 2017-18 deficit projection to come in around A$27 billion (compared to A$28.7 billion in the Mid-Year Economic and Fiscal Outlook) and that for 2018-19 to be around A$19 billion (compared to A$19.7 billion in the Mid-Year Economic and Fiscal Outlook) with the return to surplus still targeted for 2020-21. This should preserve Australia’s AAA credit rating at least for now.
Source: Commonwealth Budgets, AMP Capital
That said we are still looking at a run of 12 years of budget deficits which swamps the seven years seen in the 1990s and the five years in the 1980s. This is quite an achievement given that we haven’t had the deep recessions of the early 1980s and 1990s! Rather we have done this thanks largely to a combination of politicians ramping up spending commitments on a whole range of things without facing up to how they will be paid for. And we continue to rely inordinately on assuming the best to drive revenue up rather than taking hard decisions to limit spending growth.
Secondly, the Budget is likely to see a huge emphasis on infrastructure spending focussed on building the second Sydney airport, along with various rail and road projects mostly using public companies backed by debt. The Government’s differentiation between “bad debt” used to fund current spending and “good debt” used to fund capital works will likely clear the way and like the National Broadband Network, this debt won’t show up in the budget accounts. It makes sense to mainly use debt for spending on assets that have a long term life and the productivity enhancing potential of more infrastructure spending has much merit and can actually “crowd in” private investment. The big downside though is that the good and bad debt differentiation does nothing on its own to wind back “bad debt” and that some of the projects may turn out to be white elephants that ultimately have to be written down (like some say should occur with the NBN) in which case the debt will come back into the budget. It’s also unclear how real the ramp up in infrastructure spending will really be – last year’s budget touted a A$50 billion infrastructure spend until 2020 – will this year’s infrastructure reboot be a repackaging of that or additional net spending?
Thirdly, the Budget is likely to contain a number of measures designed to help improve housing affordability. The key elements are likely to be allowing first home buyers to save for a deposit out of pre-tax income, allowing retirees who downsize the family home to exceed the new $1.6m limit on superannuation, encouraging the supply of low cost community housing by allowing providers access to lower cost public debt (the so-called bond aggregator) and maybe imposing a nationwide vacant property tax. These things may help but only at the margin given the government’s decision not to wind back the capital gains tax discount and more importantly its inability to do much about boosting the supply of housing because that’s largely a state issue.
The Budget will likely also confirm that the yet to be passed welfare and higher education (“zombie”) savings from the 2014 budget will be dropped. With the Government already announcing a new plan for higher university fees and reduced university funding that will help offset increased school funding (Gonski 2), this still means new savings of around A$10 billion over four years will be needed to offset the dropped “zombie” savings. So expect some new welfare cuts and revenue measures with the latter possibly involving an extension of the Medicare levy surcharge.
On the superannuation front, apart from the measures to encourage downsizing, the main focus is now on bedding down the changes enacted over the last year so with a little luck it should be a super lite budget.
On the data front in Australia, expect a 4% fall back in March building approvals (Monday) but a 0.3% bounce in March retail sales (Tuesday) with a 0.7% gain in March quarter retail sales volumes. Business conditions according to the NAB survey (Monday) are likely to remain solid and May consumer confidence (Wednesday) is expected to remain just below average.
Outlook for markets
Shares remain vulnerable to a short term setback as we come into weaker seasonal months (remember the old saving “sell in May and go away and come back on St Legers Day”) with risks around North Korea, the latest softening in Chinese growth and commodity demand and worries ahead of the US Federal Reserve’s next hike next month. However, with valuations remaining okay – particularly outside of the US, global monetary conditions remaining easy and with profits improving on the back of stronger global growth, we continue to see any pullback in shares as an opportunity to “buy the dips”. Shares are likely to trend higher on a 6-12 month horizon.
Low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds. A resumption of the bond bear market looks to be getting underway and this is likely to see a gradual rise in yields.
Unlisted 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.
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%.
For the past year the Australian dollar has been range bound between $US0.72 and $US0.78, but our view remains that the downtrend in the Australian dollar from 2011 is likely to resume this year. The rebound in the Australian dollar from the low early last year of near US$0.68 has lacked upside momentum, the interest rate differential in favour of Australia is continuing to narrow and will likely reach zero early next year (as the US Federal Reserve hikes rates and the Reserve Bank of Australia holds) and constrained commodity prices will also act as a drag. Expect a fall below US$0.70 by year-end.