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Shane Oliver
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Shane Oliver is head of investment strategy at chief economist at AMP Capital.

Lower oil prices a bonus for consumers

Monday, June 26, 2017

By Shane Oliver

Global shares mostly rose over the last week, despite falls in energy shares, as economic data was mostly good and there was good news for Trump’s pro-growth agenda in the US. US shares rose 0.2%, Japanese shares rose 1%, Chinese shares rose 3% but Eurozone shares lost 0.3%. Australian shares fell 1%, thanks to a combination of falling oil prices hitting resource stocks, "fear of Amazon" weighing again on retailers and worries (mistaken in my view, given it will take so long) that China's inclusion in MSCI share benchmarks will see funds flow out of Australian shares. Bond yields were flat to down, the plunge in the oil price continued, and this, along with a slightly stronger $US, weighed on the $A.

Oil price plunges, inflation still MIA, interest rates to remain low - good news for Australian consumers

The oil price has been trending down since February amid concerns that rising non-OPEC production will offset OPEC production cuts. This hit the headlines over the last week, as the decline pushed beyond 20%. While oil is oversold and sentiment towards oil is so negative it's pointing to a bounce, it’s hard to get excited. Particularly with steadily rising shale production in the US putting a cap on price upside. 

More broadly, the weak oil price highlights the broader lack of inflationary pressure globally, which will keep interest rates low. However, low oil prices mean low petrol prices and this is positive for consumers. In Australia, if current oil prices are sustained, the retail price of petrol could fall towards $1.10 a litre. This implies a saving for the average family’s weekly petrol bill of around $6 compared to January. 

Source: Bloomberg, AMP Capital

Which is good news, given the self-inflicted wound flowing from higher electricity prices in Australia. And if oil prices stay low, or fall further, it will mean lower gas export prices which could take pressure off the domestic gas market. One can only hope!

Chinese A shares in MSCI's share benchmarks 

The inclusion of Chinese mainland (or A) shares in MSCI's share benchmarks is another sign of the opening up of the Chinese share market and its integration globally, but it has a long way to go. The inclusion only relates to large-cap shares accessible by foreigners via the Hong Kong share connection. Initially, the weight of Chinese shares in the MSCI emerging market index will be just 0.7%, whereas right now, the Chinese share market is 9% of total global share market capitalisation and it won't start phasing in till May next year.

Full inclusion may take 5-10 years. And the initial index-related flows into the Chinese share market flowing from the move are likely to be less than half typical daily turnover in the Chinese share market. So, don't expected a huge short-term impact. However, the impact on Chinese shares will grow over time, as the exposure in the MSCI indexes is likely to rise. And it’s another sign that China is now becoming an integral part of the global financial system. Over time, the increasing participation of foreign institutional investors will help enhance the rights of Chinese shareholders and add to the liquidity and reduce the speculative tendencies in the Chinese share market.

Major global economic events and implications

While the noise around President Trump continues to swirl, the past week confirmed that his policy agenda remains on track, with the Senate having released its draft Obamacare reform bill and close to a vote on it; Treasury Secretary Mnuchin and House Speaker Ryan confirming tax reform remains a top priority; a draft executive order on the health industry focussing on easing regulations and Republican election victories providing impetus to Trump's agenda.

US President Donald Trump. Source: AAP

On the data front, home sales, home prices and the leading index rose and jobless claims remain ultra weak but the Markit business conditions PMIs fell slightly in June, despite strong new orders. Major US banks also passed the first stage of the Fed’s latest bank stress tests, as would be expected in this environment.

Eurozone consumer confidence rose to its highest in 16 months and French business confidence rose to a 6-year high. Against this, the composite business conditions PMI fell slightly in June, albeit it remains strong.

Australian economic events and implications

ABS home price data confirmed continued strength in the March quarter, but a lot has happened since then, with bank rate hikes for investors and interest only borrowers, tighter lending standards and evidence the Sydney and Melbourne property markets have started to cool. Skilled vacancies remained strong in May, pointing to continued solid jobs growth for now. 

More bank mortgage rate hikes, but cuts for owner occupiers paying principle and interest. The drip feed of bank rate hikes has continued, but it’s worth putting this in perspective. Reflecting regulatory pressure and banks managing their risks, the rate hikes have been for investors, and more recently, for interest only (IO) borrowers. See the chart below. In the last week, banks have been cutting their variable rates for owner occupiers on principle and interest (P&I) loans. (Note: the chart below relates to standard variable rates, discounted rate are around 0.75% lower.)

While the hike in investor and interest-only rates (of around 0.3% for investor P&I loans, 0.75% for investor IO loans and 0.5% for owner occupier IO loans since November) are a dampener, they are modest compared to past rate-hiking cycles, investors can get up to half of it back from the tax man and nearly 80% of owner occupiers are on principle and interest loans and many of them have seen a small a rate cut over the last week.

The main uncertainty relates to the impact on interest-only owner occupiers – but, of course, if there is a problem there in terms of repayments as they move across to P&I that threatens overall economic growth, the RBA can simply offset the increase in mortgage costs by cutting the cash rate again (and yes – for owner occupiers, it’s likely the banks would pass it on).   

Source: RBA, AMP Capital

News that South Australia will add to the Federal Government’s bank levy adds to concerns that a Pandora’s box has been opened in Australia on the tax front. It’s understandable that businesses will fear that if they are in an industry that does well and is unpopular, they will be hit with a higher tax rate. Good tax policy seeks to minimise distortions with a single tax rate across all industries and we seem to be moving away from that. 

What to watch over the next week?

US data to be released in the week ahead will provide an update on business investment, consumer confidence and the Fed's preferred measure of inflation. Expect underlying capital goods orders (Monday) to show a further improvement, consumer confidence to have slipped a bit but remain strong with home prices continuing to rise (both Tuesday), pending home sales (Wednesday) to rise, May consumer spending growth (Friday) to be a bit soft and inflation as measured by the core private consumption deflator (also Friday) to fall further to around 1.4%. The combination of which will probably keep the Fed on a tightening path but only gradually.

Eurozone consumer and business confidence readings (Thursday) are likely to show continued strength consistent with stronger growth, but core inflation (Friday) is likely to remain weak and below target at around 1% year-on-year.

Japanese data to be released Friday is expected to show continuing strength in labour market indicators (helped by a falling workforce), continued strong annual growth in industrial production and continuing weakness in inflation with core inflation remaining around zero.

Chinese business conditions PMIs (Friday) will also provide a look at how growth is holding up in June. Expect the official manufacturing PMI to remain around 51.

In Australia, ABS data (Tuesday) is expected to show the population having increased by another 1.5% through 2016, further fuelling underlying housing demand and helping support potential growth in the economy. In other data, expect job vacancies data for May to have remained solid consistent with ANZ job ads, new home sales to show a continuing gradual downtrend (both Thursday) and credit growth (Friday) to have remained modest, with most interest likely to be on whether the rate of growth in property investor credit is continuing to slow.

Outlook for markets

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

Low yields point to 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%.

Our view remains that the downtrend in the $A from 2011 will resume this year. The rebound in the $A from the low early last year of near $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 Fed hikes rates and the RBA holds or cuts) and commodity prices will also act as a drag (particularly the plunge in the iron ore price). Expect a fall below $US0.70 by year end.

Eurozone shares fell 0.4% on Friday but the US S&P 500 rose 0.2% helped by strength in tech stocks. Reflecting the small positive US lead, ASX 200 futures rose 3 points or 0.1% pointing to a flat to marginally positive start to trade on Monday morning.

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'Super flows' likely helping Australian shares

Monday, June 19, 2017

By Shane Oliver

Global share markets were soft over the last week, with US shares up just 0.1% as tech stocks continued to correct, Eurozone shares down 0.8%, Japanese shares down 0.4% and Chinese shares down 1.6%. Australian shares managed a decent 1.7% rebound, as they were due for a bounce after having fallen 5% from early May highs and fund flows into superannuation ahead of a June 30 deadline for some members are likely providing a strong source of demand (which is likely to intensify into month end). Bond yields fell in the US on low US inflation data, but were little changed elsewhere. Prices for oil, gold and copper fell but iron ore managed a gain. The $A had a bounce thanks to stronger Australian jobs data.

Super boost to Aussie shares

On the superannuation boost to Australian shares this month, it’s interesting to note that while Australian consumers remain sceptical about shares as the “wisest place for their savings”, their interest in superannuation has picked up (albeit from a low base) presumably in response to recent super reforms which allow for large, one-off contributions prior to June 30. Something similar was seen in mid-2007. It’s also noteworthy how sceptical Australians remain of real estate (relative to the historical norm) according to the survey. But this has been the case for more than a year now and it hasn’t stopped further gains in Sydney and Melbourne property prices, at least until recently.

Source: Westpac/Melbourne Institute, AMP Capital 

The Fed hikes rates

The Federal Reserve provided no surprises with its fourth rate hike this cycle, no change to the so-called dot plot path for expected future interest rate hikes, some details around how it will slow reinvesting in bonds as they mature to allow its balance sheet to start returning to normal, and the usual assurances that the removal of easy money will be gradual and conditional on the economy behaving as expected.

Our view is that the Fed will hike rates once more this year in September, and commence balance sheet reduction in the December quarter. However, ongoing benign inflation is likely to see a slower path of rate hikes in 2018 and 2019 than the dot plot is implying. The absence of significant upside inflation pressures mean the Fed will remain benign and unlikely to pose a threat to US or global growth and hence share markets. 

In some ways, the situation in the US resembles the bond conundrum that Fed Chair Alan Greenspan observed in 2005. Tightening monetary policy and yet falling or low bond yields at the same time as a strong share market. While this might seem contradictory then as now it reflects reasonable growth but low inflation. Of course, back then bond yields did eventually rise but it morphed into what was commonly called “goldilocks”, “pleasantville” or “the great moderation”. Ultimately, it came to an end after excessive risk taking but it lasted for longer than many expected.

Trump noise

The noise around President Trump and Russia links continues, with talk that Trump was thinking of sacking Special Counsel Bob Mueller, who is investigating the links and then-news that Mueller was looking into a possible obstruction of justice by Trump - the leak of which may have been motivated to get Trump to back off. All of which saw an amusing tweet from Trump: “They made up a phony collusion with the Russians story, found zero proof, so now they go for obstruction of justice on the phony story. Nice.”

Source: AAP

Mueller’s probe will probably find something somewhere, even if it is not related to the Russia link. Reminds me a bit of the twists that the investigation into President Clinton took, from Whitewater to Monica Lewinsky. Our view remains that while the Democrats may find something to impeach Trump on when they get control of the House of Representatives after the November 2018 mid-terms, in the meantime, the Republicans are unlikely to impeach Trump. Rather, anticipation of the likely loss of control of Congress after November next year will see Republicans pull together to pass their pro-business agenda, including around healthcare and tax reforms. The shooting of Republican Congressional members only adds to this.

French parliamentary election 

A likely parliamentary majority for President Macron’s Republic on the Move party at Sunday’s final round French parliamentary election is probably already factored in by markets. Nevertheless, it will be a momentous occasion, with the French about to head down a market-oriented reform path starting with labour market reforms, and clearing the way for France to work with Germany to strengthen the Eurozone. The French elections coming on the back of pro-Euro outcomes in Spain, Austria and the Netherlands and almost certainly in Germany highlight diminishing political risk in the Eurozone.

While Italy remains a risk, the waning of populist support across Europe may have a spill over in Italy, the Eurosceptic Five Star Movement is unlikely to be able to form government and, in any case, the risk of a domino-like flow on from Italy to the rest of the Eurozone looks to be in retreat. Similarly, while Catalonia in Spain is aiming to have another independence referendum in October, it should be noted that polls of Catalonians show that most favour more autonomy within Spain, not independence. All of which, along with attractive valuations and a supportive ECB, is positive for Eurozone shares.

Major global economic events and implications

US data was a bit messy but consistent with reasonable growth and continuing low inflation. May retail sales were soft but already solid April sales were revised up and, in any case, regional manufacturing conditions surveys were strong in June, small business optimism remains very high, home builder conditions remain strong and unemployment claims remain around their lowest since the early 1970s.

May housing starts were weak, but are likely to bounce back given strength in other housing related indicators. Meanwhile, core CPI inflation was weaker than expected in May at 1.7% year on year. The US economy continues to look good but the lack of inflation pressure means the Fed can afford to remain gradual.

The Bank of England left rates on hold but it was more hawkish than expected. The risk of a rate hike has gone up, but Brexit uncertainty will keep the BoE on hold for a while yet. 

The Bank of Japan remained on autopilot as expected as it has committed to continuing quantitative easing and targeting a zero 10-year bond yield until inflation exceeds 2%.

Chinese activity data and credit growth for May points to growth holding up. While fixed-asset investment slowed a touch, growth in retail sales and industrial production was unchanged. While money supply growth slowed, owing to a slower shadow bank and mortgage lending, overall credit growth edged up slightly to 14.7% year on year. The overall picture is that Chinese growth has slowed after the acceleration seen earlier this year but that it remains solid at around 6.5%.

India saw a nice combination of stronger-than-expected industrial production in April and weaker than expected inflation. It remains a bright spot in the emerging world, although its share market valuations already reflect that.

Australian economic events and implications

Australian data was a bit more upbeat over the last week. While consumer confidence fell further below its long-term average, highlighting the negative impact of poor wages growth, high underemployment, rising electricity prices, etc., on households, business conditions and confidence remained solid and jobs data surprised on the upside for the third month in a row, taking the unemployment rate down to its lowest since early 2013. While the boom in jobs over the last three months should be treated with some caution, it is consistent with forward-looking labour market indicators and the jobs data, along with solid business conditions, provide a bit of an offset to other recent more negative data. The jobs data and the NAB survey support the RBA in leaving interest rates on hold for now. But, given softer data for growth, consumer spending, housing construction, non-mining investment and wages growth, our view remains that there is more risk of another rate cut than a rate hike in the next 12 months or so.

For a decade or more, political dysfunction has played havoc with Australia’s energy supply – as the uncertainty around energy policy has led to underinvestment in new capacity by both clean and dirty sources of energy - and we are now paying the price. Not only in terms of getting our emissions down, but also in terms of surging energy prices weighing on households and businesses. This is set to continue, with price rises of up to 20% this year. The problem is widely recognised but unless we can put politics aside and get agreement around energy policy – with the Finkel review providing a way forward - then the problem will only worsen and we will lose businesses and jobs to countries who have got their act together on this front.

What to watch over the next week?

In the US, Markit business conditions PMIs (Friday) are likely to remain solid at around 53 for manufacturing and 54 for services. Meanwhile, both existing home sales (Wednesday) and new home sales (Friday) are expected to rise after weakness in April and home prices are expected to show continuing strength.

Eurozone business conditions PMIs for June to be released Friday are expected to remain strong at around 56-57.

Japan’s manufacturing conditions PMI for June will also be released Friday.

In Australia, a speech by RBA Governor Lowe (Monday) will be watched for any clues on interest rates, albeit I don’t expect any. The minutes from the RBA’s last board meeting (Tuesday) will also be released with most interest likely to centre around how it sees the housing market given recent signs of a cooling in Sydney and Melbourne. March quarter ABS house price data (Tuesday) will likely show growth of around 3% quarter on quarter consistent with private surveys, but this data will be very dated given APRA’s latest tightening measures came at the end of March and since then CoreLogic data has shown a distinct softening in home prices since. 

Outlook for markets

Shares are still vulnerable to a short-term setback as we are going through a weaker seasonal period for shares with risks around Trump, North Korea, Chinese growth, the Fed and the Australian economy all providing potential triggers.

However, valuations remain okay – particularly outside of the US, global monetary conditions remain easy and profits are improving on the back of stronger global growth, so we continue to see the broad 6-12 month trend in shares remaining up. 

Low yields point to 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%.

Our view remains that the downtrend in the $A from 2011 will resume this year. The rebound in the $A from the low early last year of near $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 Fed hikes rates and the RBA holds or cuts) and commodity prices will also act as a drag (particularly the plunge in the iron ore price). Expect a fall below $US0.70 by year end. 

Eurozone shares rose 0.6% on Friday and the US S&P 500 gained 0.1%, but with tech stocks still dragging. The positive global lead and a rise in iron ore prices saw ASX 200 futures rise 9 points or 0.2% pointing to a mildly positive start to trade for the Australian share market on Monday.

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Weak or negative GDP growth?

Monday, June 05, 2017

By Shane Oliver

Share markets rose over the last week, helped by mostly good economic data and expectations that central banks will remain benign. US shares rose 1% to a new record high, Eurozone shares gained 0.5%, Japanese shares surged 2.5%, Chinese shares rose 0.2%, and Australian shares gained 0.6%. While bond yields rose in Italy on early election fears, they were flat in Australia and Japan and fell in core Europe and the US, after softer-than-expected US jobs data. Commodity prices mostly fell, but a weaker $US resulted in little change in the $A.

Are things so bad?

Are things so bad equity managers should hand all their funds back to their clients as one Australian manager is reported to have done? Putting aside speculation around other issues that may have driven the decision, there are several points to make in relation to this. First, shares globally are at risk of a correction but the combination of improved growth including solid business conditions (see the next chart), rising profits, okay valuations and low interest rates indicates the broad backdrop is reasonable.

Second, risks remain around China, but they have long been there and there is no indication it’s suddenly about to fall over. Similarly, I am expecting a pullback in Sydney and Melbourne property prices and the Australian economy remains weak, but it’s doubtful that it’s on the edge of the abyss. Fourthly, over the years, there have been numerous high profile calls to “sell everything” or “gear up big time for the great boom ahead”. Some get lucky but many not, the point being that it’s dangerous to bet everything on one big call. Finally, individual fund managers are usually chosen to fill a role in a portfolio of assets, which has been carefully constructed to meet investment goals over time with the expectation that each fund manager will manage the assets in their care in line with their process and views. So, if one manager decides to give the money back, the manager of the whole portfolio – be that a financial planner, super fund, or individual - will invariably just have to find another manager to fill the gap.

Source: Bloomberg, AMP Capital

US leaves Paris climate agreement

US President Donald Trump’s decision to leave the Paris climate agreement will have little short-term impact on markets but poses a longer-term negative for the US (and for global warming). Short term, it’s of little consequence for investment markets. It will take time for the US to exit and several key US states (notably, California) will uphold the Paris agreement and more anyway. Longer term, it’s another delay in doing something about climate change and the US will pay some price as the rest of the world pushes faster towards renewables, leaving the US behind. Of course, the next US President will likely sign up again but the delay is not helpful.

Early Italian election?

Just when it seemed "Eurozone break up risks" would be quiet for a while, there is renewed talk of an early Italian election. Their next election is due by May next year, but signs of agreement on electoral reform and a desire on the part of the governing Democratic Party to get an election out of the way before a contractionary budget due later this year, have raised again the prospect of an early election around September-October. With the populist, mostly anti-Euro Five Star Movement (5SM) tied in the polls with PD, there is a good chance that it will win the most seats. However, it's doubtful 5SM will be able to agree a coalition with the right wing Eurosceptic Northern League (which, at times, has advocated a break up of Italy). In which case, Italy will revert to a coalition involving the current government and the idea of Italy leaving the Euro will recede again. None of this will stop markets from worrying about it in the interim. But one thing that helps fade the risk of a Eurozone break up is that the elections in Europe since the Brexit vote have seen the rejection of anti-Euro parties, suggesting the risk of Italy setting off a domino effect across Europe of countries seeking to leave the Euro is low. As such, we remain upbeat on Eurozone shares.

Major global economic events and implications

US data was mostly good, with a solid May manufacturing conditions ISM, consumer confidence down a bit but still very strong, solid gains in personal income and spending in April and continued increases in home prices. US jobs data was mixed though, with payrolls up by a less-than-expected 138,000 in May, but with unemployment falling to 4.3%, underemployment falling to near pre-GFC lows, jobless claims at early 1970s levels and other job indicators remaining robust, it’s hard to conclude that the US jobs market is anything other than strong. As a result, the Fed remains on track to hike rates again this month. However, the lack of any significant acceleration in wages growth (it was just 2.5% year-on-year in May) along with core private consumption deflator inflation falling to 1.5% year-on-year in April, will keep the Fed gradual and it may even lower it’s so-called “dot plot” of rate hike expectations for next year.

Eurozone core inflation also fell in May, back to 0.9% yoy, which explains why, despite stronger activity data including another decline in unemployment and strong confidence readings, ECB President Draghi remains dovish.

Japanese data remained mixed, with strong labour market data, industrial production and a rise in the manufacturing conditions PMI but weak household spending. Depressed wages growth remains an ongoing constraint.

Chinese business conditions PMIs were confusing in May, with stronger services conditions, a flat official manufacturing PMI but a further decline in the Caixin manufacturing conditions PMI. Averaging them out suggests stable growth after the slowdown of the last few months.

Australian economic events and implications

Australian data over the last week was messy. Building approvals bounced, but the trend remains clearly down. Retail sales bounced in April allaying fears, for now, of a consumer collapse and setting up a stronger June quarter, but the bounce looks partly due to better weather and the timing of Easter and the consumer remains under some pressure. Business investment was flat in the March quarter, mining investment looks like it’s getting close to the bottom and investment plans point to a slowing in the pace of decline in business investment, but it’s still falling (see the next chart). 

Source: ABS, AMP Capital

Our estimate for March quarter GDP growth remains 0.1%, but given normal forecasting errors, a negative outcome is a very high risk.

With consumers under pressure, and the impact of Cyclone Debbie on coal exports risking a negative June quarter, there is a possibility of a technical recession. Of course, solid forward looking jobs indicators, a slowing drag from falling mining investment, and strong public capital spending all argue against getting too gloomy, but the overall picture is one of sub-par growth running well below that assumed by the RBA and in the Budget.

In our view, this all points to the rising risk of another interest rate cut, a continuation of the relative underperformance of Australian shares compared to global shares that started in 2009, and a break in the value of the $A below $US0.70.

House prices

On the house price front, CoreLogic data for May adds to evidence that the peak, at least in terms of momentum, has been seen. The drip feed of negative news regarding the Sydney and Melbourne property markets - bank rate hikes, APRA moves, surging unit supply, tightening conditions for investors and foreign buyers (with NSW moving again on foreign buyers in the last week), constant warnings of a bubble about to burst - is starting to impact. Overall, our view remains that the peak in home price growth in Sydney and Melbourne has been seen and that further weakness lies ahead, with ultimately a 5 to 10% average decline, and that unit prices in parts of Sydney and Melbourne will fall by 15-20%. In the absence of much higher interest rates, much higher unemployment and a generalised oversupply a property crash (say a 20% plus fall in average home prices is unlikely). Of course, it’s dangerous to generalise across Australia – Perth property prices are probably getting close to the bottom and Brisbane and Adelaide prices are likely to continue meandering along at around 3% year on year.

What to watch over the next week?

In the US, expect the non-manufacturing conditions ISM (Monday) to remain strong at around 57 and job openings and hiring (Tuesday) to remain solid.

The European Central Bank (Thursday) is expected to leave monetary policy on hold. While it may move to characterise the risks around its forecasts as being balanced reflecting recent strong economic activity related indicators President Draghi is likely to remain dovish and stress the need for ongoing monetary support given the lack of upwards pressure on underlying inflation. Political uncertainty around Italy will also help keep the ECB dovish.

The UK election (Thursday) has turned into a more interesting affair with the Government's poll lead declining. The most likely scenario remains that the Tories are returned with some increase in seats, which would have little bearing on Brexit. Alternatively, if Labour wins, Brexit may turn out to be softer, but expect to see a return to a pre-Thatcher world of far greater government involvement in the economy which will not augur well for productivity (oddly at a time when the French are going in the opposite direction). Either way, there are likely to be minimal implications for the global economy or Europe, which since the Brexit vote, has moved against populism.

Chinese trade data (Thursday) is likely to show export growth slowing to 7% year-on-year and import growth slowing to 9%. CPI inflation (Friday) is likely to have risen to 1.4% yoy, but producer price inflation is likely to slow to 5.5%.

Interest rates

In Australia, the RBA is likely to leave interest rates on hold for the tenth month in a row at Tuesday’s board meeting, as only a month has passed since it expressed more confidence around the outlook for growth and inflation. The RBA will likely also conclude that it’s way too early to declare victory in its efforts to slow the Sydney and Melbourne property markets, and recent strength in employment and business surveys also support the case to remain on hold for now. However, the chance of another rate cut by year end is steadily rising – growth looks like it will come in well below the RBA’s forecasts, thanks to weak consumer spending and business investment, along with slowing housing investment and subpar growth and record low wages growth is likely to keep inflation lower for longer too. In the meantime, the softening in the Sydney and Melbourne property markets will provide flexibility for the RBA to cut again if needed. The money market’s implied probability of a 20% chance of a rate cut by year end is way too low – it should probably be around 45%.  

March quarter GDP data

On the data front in Australia, the focus is likely to on March quarter GDP data to be released Wednesday, which is expected to show growth faltering again to just 0.1% quarter-on-quarter or 1.5% year-on-year, thanks to a combination of weak consumer spending, a fall in housing investment and a detraction to growth from trade.

However, data on profits and inventories (Monday) and public demand and net exports (Tuesday) will help firm up GDP forecasts and on this front, net exports are expected to be weak but public demand growth should be positive. The trade surplus for April (Thursday) is likely to show a sharp decline thanks to the impact of Cyclone Debbie on coal exports but this should reverse in May. Housing finance data for April (Friday) is likely to show a further decline. 

Outlook for markets

Shares remain vulnerable to a short term setback as we are now in a weaker seasonal period for shares with risks around Trump, North Korea, Chinese growth and the Fed’s next rate hike providing potential triggers. However, with valuations remaining okay – particularly outside of the US, global monetary conditions remaining easy and 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 sovereign bonds.  

Unlisted commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this demand 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%.

For the past year, the $A has been range bound between $US0.72 and $US0.78, but our view remains that the downtrend in the $A from 2011 will resume this year. The rebound in the $A from the low early last year of near $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 Fed hikes rates and the RBA holds or cuts) and commodity prices will also act as a drag (particularly the plunge in the iron ore price). Expect a fall below $US0.70 by year end.

Eurozone shares rose 0.6% on Friday and the US S&P 500 gained 0.4% helped by expectations that softer than expected US employment growth for May and slow wages growth will keep the Fed benign. Reflecting the positive global lead ASX 200 futures rose by 0.5% on Friday night, pointing to a roughly 25 point gain in the Australian share market when it opens on Monday morning.

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Will Aussie shares continue to underperform?

Monday, May 29, 2017

By Shane Oliver

Share markets rose over the last week, reversing the Trump FBI/Russia bump from the previous week as investors bought the dip, supported by mostly good economic and profit news. US shares rose 1.4%, Eurozone shares rose 0.04%, Japanese shares gained 0.5%, Chinese shares rose 2.3%, and Australian shares gained 0.4%. The gains in Australian shares were constrained by ongoing worries about the banks, retail shares and weakness in the iron ore price. Bond yields were flat to down, commodity prices were weak, with iron ore down 7.6%, but the $A was little changed. 

Terrorism rears its ugly head

The past week saw terrorism rear its ugly head again, this time in Manchester in the UK and our thoughts are with those affected. Despite some fears to the contrary, the financial market impact proved, yet again, to be minor with UK shares only falling 0.1% the next day before rebounding and there was no sign of any impact on other share markets.

This is consistent with the experience since early last decade that has highlighted that terrorist attacks on targets like crowds, buildings and entertainment venues, etc., don’t really have much economic impact. While the 9/11 attacks had a big short-term share market impact, with US shares falling 12%, they had recovered in just over a month; the Bali and Madrid bombings had little impact; the negative 1.4% impact on the UK share market from the London bombings of July 2005 was reversed the day after; the French share market only fell 0.1% the next trading day after the November 2015 Paris attacks and 0.3% the day after the July 2016 Nice attack.

The experience across the UK and Europe with the IRA, ETA, Red Brigades, the Red Army Faction, etc., in the 1970s and 1980s highlights that terrorist attacks can come to be seen as the norm, with people getting desensitised to them. So, while terrorism is horrible for those affected, it would need to cause more damage to economic infrastructure to have a significant economic impact and hence a significant impact on investment markets.

Moody's downgrades China's sovereign credit rating

Moody's downgrading of China's sovereign credit rating from Aa3 to A1 is unlikely to have much impact. China's debt problems are well known, with China's policy makers seeking to restrain debt, most investment in Chinese bonds is internally sourced and China is not dependent on foreign capital being the world's largest credit nation.

OPEC agrees to extend production cuts

As widely expected, OPEC agreed to extend its production cuts to March next year, but for the oil price, it was a classic case of “buy on the rumour, sell on the fact.” OPEC is basically in a bind: if it cuts supply further it will lose more market share to shale oil, but if it hiked production, oil prices will plunge again. So, it chose the middle path.

Trump's Budget

President Trump's fuller budget request released in the last week is best ignored. As always, Congress will put the budget together - Trump doesn't even need to sign it off.

Aussie bank downgrades

The latest Australian bank rating downgrades tell us nothing new, but the drip feed of negative news around the property market in Sydney and Melbourne is continuing to mount - surging unit supply, bank rate hikes, tightening lending standards, reduced property investor tax deductions, ever tighter restrictions around foreign buyers, etc. Our view remains that home price growth has peaked in Sydney and Melbourne and that price declines lie ahead, particularly for units. The extent of the unit construction boom in Sydney is highlighted by the residential crane count, which has increased from just 62 in September 2014 to 292 in March. 

Source: Rider Levett Bucknall Crane Index, AMP Capital

Global over Aussie shares

Still prefer global over Australian shares. Much of the relative underperformance of the Australian share market versus global shares since 2009 - which reflected relatively tighter monetary policy in Australia, the commodity slump, the lagged impact of the rise in the $A above parity and a mean reversion of the 2000 to 2009 outperformance - has been reversed.

However, the Australian share market looks likely to continue underperforming going forward, reflecting weaker growth prospects in Australia - with the economy looking like it may have stalled again in the March quarter, the housing cycle peaking and turning down, constraints on consumer spending (high debt, higher bank lending rates, slowing wealth affects, rising energy costs, record low wages growth and high underemployment), risks around the banks and uncertainty around the outlook for bulk commodity prices.

We still see the ASX 200 higher by year end, but global shares are likely to do better on both a hedged, and particularly unhedged, basis.

Source: Thomson Reuters, AMP Capital

Major global economic events and implications

US data was mostly good, with the highlight being a rise in the overall business conditions PMI for May pointing to reasonable growth. Meanwhile, home sales fell, but home prices continued to rise, and March quarter GDP growth was revised to 1.2% annualised, from 0.7%. The main dampeners were weaker-than-expected trade, inventory and durable goods data. The minutes from the last Fed meeting confirmed that the Fed is likely to hike rates again in June and looks to be on track to start running down its balance sheet (i.e, reversing quantitative easing) from later this year by letting a gradual amount of maturing bonds roll off each month. Rate hikes and balance sheet reduction all remain conditional on the economy continuing to behave though.

Eurozone business conditions PMIs remained very strong in April and business confidence rose in Germany and France, which is all consistent with strengthening growth in Europe. 

Japanese inflation rose slightly in April, but with core inflation still zero, the Bank of Japan is set to continue quantitative easing and its zero 10-year bond yield policy for a long time.

Australian economic events and implications

Australian March quarter construction data fell, adding to the downside risks to March quarter GDP growth. However, it’s not all bad as the 4.7% slump in residential construction looks temporary and likely to reverse in the current quarter as the impact of Cyclone Debbie drops out and the huge pipeline of work yet to be completed kicks in. Also, public construction is up strongly reflecting state infrastructure activity, and December quarter construction activity was revised up significantly.  

Weak March quarter construction activity, along with very weak retail sales and a likely growth detraction from net exports, highlights that absent an upside surprise in public spending, equipment investment or inventories, March quarter GDP growth looks likely to be near zero with the risk of another contraction. Reflecting this, along with ongoing softness in underlying inflationary pressures, there is far more risk of another RBA rate cut by year end than a rate hike.

What to watch over the next week?

In the US, the focus is likely to be on the May ISM manufacturing conditions index (Thursday) and jobs data (Friday). The ISM is likely to have remained solid at around 55 and jobs data is likely to have remained strong with a 175,000 rise in payroll employment and unemployment remaining unchanged at 4.4%, but wages growth modest at around 2.7% year on year (yoy). In other releases, expect solid growth in April consumer spending, but a fall back in inflation as measured by the core personal consumption deflator to 1.5% yoy and consumer confidence in May to have remained strong (all due Tuesday), pending home sales (Wednesday) to reverse a fall seen in March, and the April trade deficit (Friday) to deteriorate.

Eurozone business and consumer confidence readings for May (Tuesday) are expected to remain solid and unemployment (Wednesday) is likely to have fallen to 9.4% from 9.5%, but core inflation is likely to fall back to 1% yoy from 1.2% reversing a distortion in April due to Easter.

Japanese jobs data for April is expected to remain solid - helped of course by a falling workforce, but household spending data is likely to remain weak (all due Tuesday) and industrial production data (Wednesday) is likely to show a bounce.

Chinese business conditions PMIs (Tuesday and Wednesday) are expected to soften marginally.

In Australia, expect building approvals (Tuesday) to show a 3% gain after a sharp fall in March, credit growth (Wednesday) to remain moderate, CoreLogic data to show a further moderation in home price growth, retail sales to show a 0.2% bounce after several soft months and March quarter business investment data to show a 0.5% decline as mining investment continues to fall (all due Thursday). Of most interest in the investment data will be investment intentions which are expected to show some improvement in non-mining investment.

Outlook for markets

Shares remain vulnerable to a further short-term setback as we are now in a weaker seasonal period for shares with risks around Trump, North Korea, Chinese growth and the Fed’s next rate hike providing potential triggers. However, with valuations remaining okay – particularly outside of the US, global monetary conditions remaining easy and 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 sovereign bonds.  

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 $A has been range bound between $US0.72 and $US0.78, but our view remains that the downtrend in the $A from 2011 will resume this year. The rebound in the $A from the low early last year of near $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 Fed hikes rates and the RBA holds or cuts) and commodity prices will also act as a drag (particularly the plunge in the iron ore price). Expect a fall below $US0.70 by year end.

Eurozone shares fell 0.1% on Friday and the US S&P 500 rose just 0.03%. ASX 200 futures gained 7 points or 0.1% on Friday night pointing to a flat to slight positive start to trade for the Australian share market on Monday morning, although a further 3.9% plunge in the iron ore price is likely to weigh on mining stocks.

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Trump crisis likely to speed up US tax reform

Monday, May 22, 2017

By Shane Oliver 

Most global share markets fell over the last week on the back of the political crisis around President Trump. US shares fell 0.4% after recovering some of their losses later in the week, Eurozone shares fell 1.1%, Japanese shares fell 1.5% and Australian shares fell 1.9%. Australian shares are now down around 4% from their high earlier this month. They've been hit by the weak global lead, pressure on the banks as a result of the Budget’s bank levy, expectations for slowing credit growth and weakness in retailers on the back of weak retail sales, and fears around the competitive threat from Amazon. Chinese shares managed to buck the global trend and see a 0.6% gain. Reflecting the "risk off" environment, bond yields generally fell, but commodity prices mostly rose helped by a falling US dollar. The weaker $US and good jobs data also helped support a small bounce in the $A. 

The Trump trade

The standard narrative right now seems to be that the “Trump trade” drove the surge in global share markets since the US election and that this will now reverse because of the political crises now surrounding President Trump. This is too simplistic and likely to be wrong. First, the main reason for the rally in shares since last November has been the improvement in economic conditions and surging profits that has occurred globally and not just in the US and which had little to do with Trump. Second, the political crisis around Trump won’t necessarily stop the pro-business reform agenda of the Republicans. In fact, unless things become terminal for Trump quickly, it’s more likely to speed it up. There is no doubt the political risks around Trump worsened over the last week, with increasing talk of impeachment and concern that it will impact the Republican’s tax reform agenda. However, it’s a lot more complicated than that: 

  1. First, impeachment is initiated by the House of Representatives and can be for whatever reason the majority of the House decides. Conviction, removal from office, is determined by the Senate and requires a two thirds majority. 
  2. At present, Republicans control the House with a 21 seat majority and won’t vote for impeachment unless it’s clear that Trump committed a crime (and so far it isn’t obvious that he has) and/or support for him amongst Republican voters (currently over 80%) collapses.

However, Trump’s overall poll support is so low that if it does not improve the Democrats will gain control of the House at the November 2018 mid-term elections and they will likely vote to impeach him (they hate him and will almost certainly find something to base it on much like the Republican Congress found reason to impeach President Clinton). Then, it’s a question of whether Trump can get enough support amongst Republican Senators to head off a two thirds Senate vote to remove him from office (Clinton was not removed from office because Democrat and some Republican senators did not support the move to do so).

This is all a 2019 and beyond story anyway, but the point is that Republicans only have a window out to November next year to get through the tax cuts/reforms they agree with Trump should happen. So if anything, all of this just speeds up the urgency to get tax reform done because after the mid-terms, they probably won’t be able to.

Now, there is another way for the Vice President and Cabinet to remove a President from office under the 25th Amendment of the Constitution which is aimed at dealing with a President who has become mentally incapable. While some may claim this one is a no brainer, Vice President Pence is a long long way from doing this.

Tax reform - the bottom line

The bottom line is that while the noise around Trump and particularly the FBI/Russia scandal will go on for while, it does not mean that tax reform is dead in the water. In fact, unless it becomes obvious that Trump has committed a crime resulting in the Republican’s themselves moving to impeach him, it’s more likely to speed up tax reform and other measures that do not require any Democrat support in the Senate. On this front, work on tax reform is continuing including in the Senate and Trump’s infrastructure plan (which is likely to be around leveraging up Federal spending and encouraging states to privatise their assets and recycle the proceeds) and looks likely to be announced soon.

The impact of past impeachments on the US share market is mixed and proves little. The unfolding of the Watergate scandal through 1973-74 occurred at the time of a near 50% fall in US shares but this was largely due to stagflation at the time. (Out of interest, President Nixon resigned before he was impeached.) President Clinton’s impeachment had little share market impact but it was in the midst of the tech bull market.

Share markets have had a great run and are due a decent 5% or so correction as a degree of investor complacency (as indicated by an ultra-low VIX reading two weeks ago) has set in and the latest scandal around Trump may just be the trigger. North Korean risks are another potential trigger and after all it is May (“sell in May and go away …”). Australian shares are down 4% from their high early this month, but global shares are only down 2% or so. However, providing the current Trump scandal largely blows over for now, allowing tax reform to continue, it’s unlikely to derail share markets beyond any short term correction. Valuations are reasonable – particularly for share markets outside the US, global growth is looking healthier, profits are rising (by around 14-15% year on year (yoy) in the US and Japan and by 24% yoy in Europe) and global monetary conditions remain supportive of shares.

It seems to have been a week for political scandals. Aside from those around Trump, a corruption scandal has engulfed Brazilian President Temer, highlighting that big risks remain around Brazil and allegations have emerged regarding Japanese PM Abe (although he is likely to survive them).

Major global economic events and implications

US economic data was mostly good. Housing starts fell in April, but driven by volatile multis and a further increase in the already strong NAHB homebuilders index points to strong housing conditions going forward. While the New York regional manufacturing conditions index fell in May, it rose in the Philadelphia region and industrial production rose sharply in April. Meanwhile, jobless claims remain at their lowest since the early 1970s. All of this is consistent with the Fed hiking rates again next month. The political noise around Trump will only impact the Fed if shares and economic conditions deteriorate significantly and that looks unlikely.

 The Japanese economy accelerated to 0.5% quarter on quarter in the March quarter driven by consumption and trade taking annual growth to 1.6% year on year. This was the fifth consecutive quarter of growth, the first such run in 11 years.

Chinese data for industrial production, retail sales and fixed asset investment slowed in April, consistent with other data indicating that recent policy tightening is impacting. Our view remains that GDP growth will track back from March quarter growth of 6.9% year on year to around 6.5%. The Chinese authorities have little tolerance for a sharp slowing in growth and policy makers are already showing signs of easing up on the policy brake. Meanwhile, property price growth seems to have stabilised around 0.5% a month over the last few months, but is still slowing in Tier 1 cities.

Australian economic events and implications

Australian data was mixed. Jobs growth was strong again in April and forward looking jobs indicators point to continuing strength ahead, but consumer confidence fell and wages growth remained at a record low of just 1.9% year on year. 

While the good jobs numbers will help keep the RBA on hold for now regarding interest rates, the continuing weakness in wages growth is a concern and highlights ongoing downwards risks to growth, inflation and the revenue assumptions underpinning the Government’s projection of a return to a budget surplus by 2020-21. With unemployment and underemployment remaining in excess of 14% it’s hard to see what will turn wages growth up any time soon. So, while our base case is that interest rates have bottomed, if the RBA is going to do anything on interest rates this year it will more likely be another cut than a hike. Particularly if property price growth in Sydney and Melbourne slows.

What to watch over the next week?

OPEC meets Thursday and is likely to extend its oil supply cuts in the face of rising US shale oil production. OPEC is in a bind: if it cuts supply further it will lose more market share to shale oil but if it hikes production oil prices will plunge again.

In the US, expect the minutes from the last Fed meeting (Wednesday) to remain consistent with another rate hike at the Fed's June meeting, and the Markit manufacturing conditions PMI for May (Wednesday) to show a slight improvement from April's reading of 52.8. New home sales (Tuesday) and existing home sales (Wednesday) are expected to fall back slightly after strong gains in March, home prices (Wednesday) are expected to show a further gain and April durable goods orders (Friday) are expected to remain consistent with continued reasonable growth in business investment. March quarter GDP growth (Friday) is likely to be revised up to 0.9% annualised from an initially reported 0.7%.

In Europe, expect May business conditions PMIs (Wednesday) to remain strong consistent with stronger economic growth.

Japanese core inflation for April (Friday) is expected to remain around zero, consistent with the Bank of Japan maintaining a zero 10-year bond yield and quantitative easing for a long time. 

In Australia, March quarter construction data is expected to show continued softness in mining related engineering construction but gains in residential and non-residential construction. Speeches by RBA officials Debelle, Bullock and Richards will be watched for any clues on interest rates.

Outlook for markets

Shares remain vulnerable to a further short-term setback as we are now in a weaker seasonal period for shares with risks around Trump, North Korea, Chinese growth and the Fed’s next rate hike next month providing potential triggers. However, with valuations remaining okay – particularly outside of the US – global monetary conditions remaining easy and 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 sovereign bonds.  

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 $A has been range bound between $US0.72 and $US0.78, but our view remains that the downtrend in the $A from 2011 will resume this year. The rebound in the $A from the low early last year of near $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 Fed hikes rates and the RBA holds) and constrained commodity prices will also act as a drag. Expect a fall below $US0.70 by year end.

Eurozone shares rose 0.8% on Friday and the US S&P 500 gained 0.7% recovering some of the Trump related hit to markets seen earlier in the week. Reflecting the positive global lead and a rise in iron ore prices ASX 200 futures rose 0.5% on Friday night pointing to 25 point gain at the open for the Australian share market on Monday. 

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Weekly economic and market report

Monday, May 15, 2017

By Shane Oliver

The last week saw US shares hit a new record high but end the week down 0.4%. Eurozone shares fell 0.5% with a bit of profit taking after the French election, but Australian shares were flat, Chinese shares rose 0.1% and Japanese shares gained 2.3%. Bond yields generally fell slightly in major countries despite good economic data and commodity prices were mixed with oil up (on lower US stockpiles) but copper and iron ore were down. The latter, and a rise in the $US, weighed on the Australian dollar. 

The French election

The French presidential election panned out even a bit better than the polls indicated, with Macron winning 66% of the vote. Coming on the back of the Spanish, Austrian and Dutch elections it is clear that Eurozone countries continue to reject the nationalism and populism evident in the Brexit and US elections. France under Macron is likely to move down a path of economic reform, openness and working with Germany to strengthen the Eurozone. This is good for France, Europe and the Euro but because the French outcome had largely been factored in after the first round vote there was a bit of "selling on the fact" in the last week.

The focus now turns to the June 11 and 18 parliamentary elections in France, which are likely to see an outcome where Macron's La Republique En Marche party takes the most or maybe even a majority of seats and a centrist reformist government is supported, and then the German election in September, where Merkel is looking stronger and support for the nationalist AFD is trivial.

So, political risk in Europe has declined. It will ramp up ahead of the Italian election next year though - but even there, it’s doubtful Italy will leave the Euro. Despite the diminished political risk in Europe for now, the absence of higher underlying inflation pressures means the ECB is unlikely to back away from current supportive monetary policy settings any time soon. As ECB President Mario Draghi has pointed out, it's "too early to declare success" in lifting inflation. This is all good for Eurozone shares which should benefit from attractive relative valuations, rising economic growth and profits and a stimulatory ECB. Even Greece is looking good by the way.

The US

In the US, the political risk around the Trump Administration rose a notch with the firing of FBI director, James Comey, in the midst of the FBI's investigation into the links between Russia and the Trump presidential campaign. At this stage, this is just a political and not an economic/financial issue. But, to the extent that it adds to the risks around the GOP losing the House and Senate after next year's mid-terms and the risk of a Trump impeachment thereafter, if anything, it actually increases the pressure on the Republicans to pass healthcare and tax reform quickly. However, while these measures are not planned to require any Democrat support in the Senate, measures that do require Democrat support (e.g., Dodd Frank regulatory changes, ramped up infrastructure related spending) are looking less and less likely to pass.

Federal Budget

In Australia, the Federal Budget signalled a further shift from austerity to populism. The big positives include new spending measures being funded, retention of the target to return to surplus by 2020-21, a further ramp up in needed infrastructure spending and a more comprehensive than expected housing affordability package which may not make much short term difference but could have a big impact on a three to five year time frame if the plan to reward states for meeting housing supply targets is implemented. The negatives though include a 12-year run of budget deficits that swamp anything seen in the past (and I worry that increasingly no one seems to really care), very optimistic revenue assumptions which point to another delay in reaching the surplus target, a risk that some of the infrastructure projects will see "good debt" become "bad", a big element of tax and spend, and a populist tax on big banks, which some say begs the question of which sector might be next? 

The danger is that the focus on levy/tax hikes has opened the door to further tax increases as part of a compromise to pass the Budget through the Senate with the Opposition proposing that the 2% budget repair levy be continued for high income earners on top of a 0.5% increase in the Medicare levy, taking the top tax rate to 49.5%. The danger is that the Australian personal tax system is already highly progressive with the top 3% of taxpayers already contributing around 30% of the income tax revenue raised by Canberra. A top rate of 49.5% would be at the high end of comparable countries and compares to just 33% in New Zealand, 22% in Singapore and 15% in Hong Kong. Not great for incentive.

Major global economic events and implications

US data remains consistent with strong economic conditions with: a solid April retail sales report, continued strength in consumer sentiment, job openings, hiring and people quitting for other jobs remaining high, jobless claims remaining ultra-low, and small business optimism remaining about as strong as it’s ever been. Meanwhile, underlying consumer price inflation was weaker than expected in April and fell to 1.9% year on year after being as high as 2.3% in January. Solid economic data keeps the Fed on track to hike rates again in June and September, but soft inflation means that it will remain gradual.

A slowing in Chinese export and import growth is consistent with some recent loss of momentum in China (although prior months were a bit too strong to be believed) and slowing producer price inflation as the surge in commodity prices drops out points to a slowing in nominal growth. Chinese data continues to run hot and cold and after the heat of late last year and early this year the authorities have tapped the brakes again. However, there is little tolerance for much of a slowdown, so if things do slow too much it won't take much to shift back to the accelerator.

Australian economic events and implications

Risk of another GDP contraction in the March quarter. Australian economic data was a mixed bag, with strong readings for business confidence and ANZ job ads but a further leg down in building approvals and very soft retail sales. The peak in building approvals is now well behind us and this will show in slowing growth in dwelling construction activity this year and a contraction next year. 

Source: Bloomberg, AMP Capital

More immediately, the weakness in March quarter real retail sales (up just 0.1% quarter on quarter), coming on the back of the previous week's data showing that net exports will likely detract from growth again in the March quarter, points to the risk of a very weak and maybe even negative March quarter GDP outcome. Which, in turn, highlights downside risks to the Government's growth (and wages) assumptions. More importantly, with the Budget providing no net stimulus to the economy (in fact it’s a detraction) it still falls to the RBA to do the heavy lifting on the economy and, on this front, soft recent data and the implications for inflation make it clear that another rate cut in Australia is far more likely than a rate hike this year. With housing set to slow at a time when mining investment is still falling (albeit with a lessening impact), public investment spending and a strong contribution to growth from services exports like tourism and higher education are critically important. The latter points to the ongoing need for a lower $A - which I see falling below $US0.70 by year end.

What to watch over the next week?

In the US, expect to see the NAHB home builders’ conditions index (Monday) remain strong, April housing starts post a solid rebound after a weather affected decline in March and continued growth in industrial production (both due Tuesday). New York and Philadelphia regional manufacturing conditions surveys will also be released.

Japanese GDP growth for the March quarter (Thursday) is expected to show continued modest growth of 0.4% quarter on quarter or 1.8% year on year.

Chinese economic activity data for April to be released today is expected to show a slight softening after recent strength as tightening policies start to bring growth back into line with target. Expect to see growth in industrial production slow from 7.6% year on year to 7.1%, fixed asset investment slow to 9.1% (from 9.2%) but retail sales growth to remain at 10.9%.

In Australia, March housing finance data (Monday) is expected to show a slight gain after falling in February, the minutes from the RBA’s last board meeting (Tuesday) are likely to confirm a basically neutral bias on interest rates, March quarter wages growth is expected to be 0.5%, leaving annual growth at a record low of 1.9% year on year and consumer confidence will be watched for any boost from the Budget (both Wednesday) and April employment data (Thursday) is expected to show a 5,000 gain after a massive rise in March, with unemployment remaining around 5.9%. 

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 Fed’s next hike next month. However, with valuations remaining okay – particularly outside of the US, global monetary conditions remaining easy and 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 $A has been range bound between $US0.72 and $US0.78, but our view remains that the downtrend in the $A from 2011 will resume this year. The rebound in the $A from the low early last year of near $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 Fed hikes rates and the RBA holds) and constrained commodity prices will also act as a drag. Expect a fall below $US0.70 by year end.

Eurozone shares gained 0.3% on Friday, but the US S&P 500 lost 0.1%. Despite the softish US lead, ASX 200 futures rose 6 points or just 0.1%, possibly helped by a higher close in iron ore prices in China, and this points to a flat to slight positive open for the Australian share market today.

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Budget preview: 3 key focus areas

Monday, May 08, 2017

By Shane Oliver

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 $A which looks to be breaking down again.

No surprises from the Fed

In the US, the Fed 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 Fed’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 the Fed 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 he was thinking about raising gasoline tax to fund infrastructure and break up the banks into banking and trading arms, both are unlikely with little support in Congress. Elsewhere, there was good news on the policy progress front with a government shutdown avoided (at least out to 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.  

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 ISM index, the non-manufacturing conditions ISM index rose, the trade deficit was better than expected and jobs data was solid. March quarter profits continue to impress with 78% beating on earnings, 65% beating on sales 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 up 24% year on year.

China’s official and Caixin business conditions PMIs slipped in April consistent with the view that recent policy tightening has impacted, that the upswing in growth momentum is likely over and that growth this year will be constrained around 6.5%. 

Australian economic events and implications

In Australia, the RBA 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 RBA’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 RBA 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 $A.

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 RBA’s flexibility on rates. While RBA 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 RBA will be on hold out to the second half of 2018 when rates will start to rise. 

On household debt and house prices, Governor Lowe provided a good analysis of the RBA’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 RBA 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 in April. Meanwhile, the AIG’s manufacturing and services conditions PMIs for April were strong pointing to solid economic growth but 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 another growth detraction from net exports 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. 

Budget deficit projections

First, after years of Budget 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 wages 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 $27bn (compared to $28.7bn in MYEFO) and that for 2018-19 to be around $19bn (compared to $19.7bn in MYEFO) with the return to surplus remaining in 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. And 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. 

Infrastructure spending 

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 NBN Co 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 $50bn infrastructure spend until 2020 – will this year’s infrastructure reboot be a repackaging of that, or additional net spending?

Housing affordability 

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 Governments 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’s 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 2.0), this still means new savings of around $10bn 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 Fed’s next hike next month. However, with valuations remaining okay – particularly outside of the US, global monetary conditions remaining easy and 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 $A has been range bound between $US0.72 and $US0.78, but our view remains that the downtrend in the $A from 2011 is likely to resume this year. The rebound in the $A from the low early last year of near $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 Fed hikes rates and the RBA holds) and constrained commodity prices will also act as a drag. Expect a fall below $US0.70 by year end.

Eurozone shares rose 0.8% on Friday and the US S&P 500 gained 0.4% to a record high helped along by good jobs data. The positive global lead saw ASX 200 futures rise 55 points or 0.9% pointing to a strong open for the Australian share market on Monday morning.

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'Risk on' thanks to France and Trump's tax plan

Monday, May 01, 2017

By Shane Oliver

The past week saw “risk on” following the outcome of the first round of the French election and in anticipation of President Trump’s tax plan. Mostly good economic and earnings news helped too. This saw US shares up 1.5% for the week, Eurozone shares up 3.4%, Japanese shares rise 3.1% and Australian shares gain 1.8%, but Chinese shares dipped 0.8% on news of tighter financial regulation. Reflecting the ''risk on'' tone bond yields rose in core countries (but fell sharply in France), but commodity prices were mixed and the $A fell.

There has been a lot of action on the policy front in the US over the last week – most of which has been positive:

President Trump's much anticipated tax plan provided few surprises: a reduction in the corporate tax rate to 15% (from 35%); a one-off tax on repatriated cash earnings (of 10%); no border adjustment tax (it’s just too hard); collapsing the personal tax brackets from seven to just three of 12%, 25% and 33% (with the current top bracket being 39.6%); doubling the tax free threshold to $US24,000; and cutting itemised deductions. While it was short on details, this is to be expected as it is really just an opening statement of principles with agreement to be reached with Republicans in Congress who have their own plans that head in the same direction, i.e. lower rates. So compromise is likely - probably resulting in a corporate tax rate of 20% rather than 15%. If the package is “revenue neutral” after 10 years - helped by savings from Obamacare reform, less deductions and "dynamic scoring" which takes account of a possible growth dividend then it should pass Congress with just a simple majority in the Senate (which the Republicans’ have). But, if it’s not revenue neutral, 8 Democrat senators will be needed to support it and that’s a big ask - so expect it to be "revenue neutral", although that still means a boost to growth. There is a long way to go yet so tax reform may not make it into law until early next year. But what the plan shows is that tax reform remains high on the President's agenda and this is all that matters for markets.

Trade got back in headlines over the last week, with the US imposing countervailing tariffs on Canadian softwood, investigating imports in relation to the steel and aluminium industries and talk of withdrawing from NAFTA. However, tariffs were deployed under Bush and Obama at times and Trump denied a withdrawal from NAFTA in favour of renegotiation. All of which sounds like bargaining noise. But we remain a long way from the trade war many fear. 

A US Government shutdown looks unlikely – with Congress agreeing on funding for a week and close to reaching a longer term funding agreement.

Of course, risks remain high around North Korea as it test fired another missile (which looks to have failed), although Trump indicated he prefers a diplomatic solution.

The French election

The first round of the French election saw a good result for markets (and France) with the centrist Macron wining 24% of the vote and the far-right anti Euro Le Pen on 21.3% to now face each other in the run-off election on May 7. Macron’s relatively complacent post-election speech and team dinner in an up market restaurant did not get his round two campaign off to a strong start with Le Pen’s side playing up his establishment credentials. A portion of those who voted for centre-right Fillon and far-left Melenchon may also transfer their support to Le Pen and some 20-30% of voters may abstain. More terrorist attacks may also boost support for Le Pen. So, a Le Pen victory is still possible. If this were to occur, French citizens and investors would fear she will find a way out of the Euro even though there are immense barriers to such a move and this would likely see runs on French banks (remember Greece in 2015), a surge in French bond yields relative to German yields and a renewed bout of Eurozone break up fears weighing particularly on the Euro and Eurozone shares but also on global shares as was the case at the height of the Eurozone crisis in 2011-13. However, against this, Macron has a solid poll lead of around 20% against Le Pen which is far wider than the 4% poll error seen in the Brexit vote and the 2% poll error seen in the US election. This is narrowing a bit – which may be a good thing in order to stop complacency sinking in - but our base case is that with the majority of the French wanting to stay in the Euro and negative towards the far right National Front that Le Pen represents Macron will ultimately win on May 7. Expect some nervousness along the way though. 

Major global economic events and implications

US data was mostly good with a gradual rising trend in capital goods spending orders, solid home sales, continuing gains in home prices and still high consumer confidence. Meanwhile, March quarter profits continue to surprise on the upside. We have now seen 58% of companies report with 81% beating on earnings and 65% beating on sales. Earnings are up 12% year on year and on track for the fourth quarterly gain to new record highs. While March quarter GDP growth slowed to just 0.7% annualised, this appears to reflect a seasonal distortion that will reverse in the June quarter. Over the last 20 years March quarter growth has been about 1% weaker than the other quarters and has been followed by a June quarter rebound. Solid business conditions readings, strong profit growth and ultra low jobless claims also indicate underlying growth is much stronger and the 1% March quarter growth detraction from inventories won’t be repeated. 

As expected, the ECB made no changes to monetary policy with President Draghi more upbeat on growth but remaining relatively dovish on the back of weak core inflation. Meanwhile, April confidence readings in the Eurozone pushed up to the highest levels since before the GFC. While inflation bounced in April this was largely due to a seasonal distortion due to Easter.

The Bank of Japan also remained on hold consistent with its commitment to continue quantitative easing and zero bond yields until inflation exceeds 2%. Given core inflation fell to -0.1% yoy in March this will be the case for a long time. 

Australian economic events and implications

In Australia, headline inflation rose to 2.1% year on year in the March quarter putting it back in the RBA’s 2-3% target range. This is good news to the extent it signals that the risk of deflation has receded. But it’s too early to get excited. The cost of living is now rising faster than wages and this will act as a drag on household spending. And abstracting from higher petrol prices and increases in prices for government influenced items like utilities, health and education underlying inflation in the market sector of the economy remains too low at just 1% year on year. 

In other data, producer price inflation remains soft, skilled vacancies fell for the second month in a row, which is a bit of a concern, credit growth remained weak with lending to property investors slowing but a surge in export prices in the March quarter points to another rise in Australia’s terms of trade.

Meanwhile, with the Federal Budget close, two things are worth highlighting. First, the Government is playing down what it can deliver on housing affordability – maybe a few fiddles to encourage downsizing but since the big issue is supply and that is a state issue there is not really much it can do. Second, its new-found focus on distinguishing between “good” debt (where debt is used to finance investment in assets like infrastructure that have a long term payoff) and “bad” debt (where debt is used to finance current spending) makes some sense. There is logic in using debt mainly for assets as it spreads the cost of paying for them to future generations who will benefit from them and such an approach may help reinvigorate the focus on getting current spending under control. The danger though is that it just results in a smoke and mirrors trick that allows a further ramp up in debt with no real slowing in recurrent spending. Ratings agencies would just see through that and such an approach did not help the WA Government. That said, it does look like there will be a ramp up in debt financed infrastructure spending in the coming budget.

What to watch over the next week?

In the US, the Fed (Wednesday) is expected to make no changes to monetary policy but signal ongoing confidence in the US outlook and that a gradual normalisation of monetary policy remains appropriate consistent with another rate hike in June and a start to letting its balance sheet decline later this year. Meanwhile, expect the April ISM business conditions indexes (Monday and Wednesday) to remain strong at around 56, the core consumption deflator for March (Monday) to fall to 1.6% year on year and March employment growth to bounce back to a solid 195,000 but wages growth to remain at 2.7% year on year. US March quarter earnings will continue to flow.

In the Eurozone, expect unemployment (Tuesday) for March to fall to 9.4% from 9.5% and March quarter GDP growth (Wednesday) is expected to rise 0.6% quarter on quarter or 1.8% year on year.

China’s Caixin manufacturing conditions PMI (Tuesday) is expected to rise slightly to 51.4.

In Australia, the Reserve Bank (Tuesday) is expected to leave the cash rate on hold at 1.5% for the ninth month in a row. The rise in headline inflation to back within the RBA’s 2-3% target zone has reduced the pressure to cut rates again at a time when the RBA would rather not cut any way given worries about the Sydney and Melbourne property markets, but continuing low underlying inflation pressure at a time of very high underemployment, record low wages growth and a still too high $A means that its way too early to be thinking about raising rates. Our base case remains that the RBA will be on hold out to the second half of 2018 when rates will start to rise. The RBA’s quarterly Statement on Monetary Policy (Friday) is unlikely to make any significant changes to its forecasts. On the data front, expect CoreLogic data (Monday) to show a stalling in home price growth in April possibly reflecting softer investor demand on the back of higher bank rates, tighter lending standards and all the bubble talk. The March trade surplus (Thursday) is likely to have fallen.

Outlook for markets

Shares remain vulnerable to short term setbacks particularly given the risks around North Korea and the final round of the French election. But with valuations remaining okay, global monetary conditions remaining easy and 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 $A has been range bound between $US0.72 and $US0.78, but at some point this year the downtrend in the $A from 2011 is likely to resume as the interest rate differential in favour of Australia narrows (as the Fed hikes rates and the RBA holds), as the Fed eventually moves to reduce its balance sheet and hence narrow measures of US money supply and as the iron ore price remains down from its February highs.  

Eurozone shares fell 0.1% on Friday and the US S&P 500 lost 0.2%. As a result of the soft global lead ASX futures fell 0.1% pointing to an 8 point decline for the ASX 200 when it opens on Monday morning.

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Macron to face Le Pen: A good outcome for investment markets

Monday, April 24, 2017

By Shane Oliver

As suggested by opinion polls, the centrist pro-Euro candidate Emmanuel Macron will face far right anti-Euro National Front candidate, Marine Le Pen, in the May 7 run-off vote for President of France. 

With around 80% of the vote counted, Macron is on track to take 23.4% of the vote, with Le Pen on 22.6%, centre-right Francois Fillon on 19.9% and far-left Jean-Luc Melenchon on 18.9%. This is pretty much in line with recent polls and along with the Netherlands election, provides a vindication of them. 

This result is positive for investment markets, with the Euro up around 1.5% from Fridays close, as in recent weeks there was a fear that Melenchon would make the run off against Le Pen as both advocate policies that would threaten the Euro (albeit Melenchon a bit less so) and would be negative for the French economy (increasing state participation in the economy, deficit spending, more regulation, etc).

With all the talk about a populist/nationalist surge across Europe, supposedly on the back of the Eurozone public debt and migration crises, the Brexit and Trump wins, and Thursday's latest terrorist attack in France, the surprise for many may have been that Le Pen did not do better. In fact, poll support for her looks to have peaked at the tail end of the Eurozone crisis in 2013 when it got as high as 35%. 

Support for nationalists in Europe has been wildly exaggerated and the first round of the French poll marks the fourth election since Brexit - Spain, Austria, the Netherlands and now France - that has seen the nationalists do less well than expected. The majority of the French support remaining in the Euro and this works against nationalist extremists as was shown a few years ago in Greece where Syriza only attained power after dropping its anti-Euro policies and is now just another centrist European party. Perhaps also the Europeans have seen Brexit and the US election outcome and decided that’s not for them.

However, the French election won't be over until May 7. Macron's policies seek to strengthen the European Union, maintain openness and are mildly reformist for France - which would be good for the Euro and the French economy. However, Le Pen wants to re-establish the Franc for domestic transactions and allow the Bank of France to print money to finance deficit spending. Whilst her National Front won't win control of the National Assembly (parliament) in June elections, and so the new French Government will not implement many of her policies and a referendum to exit the EU and Euro is unlikely to pass given majority support to remain in the Euro, this won't stop French citizens and investors generally, from fearing that she will find a way to exit the Euro if she wins the presidency in the May 7 run-off. So, a Le Pen victory would likely see runs on banks (remember Greece in 2015), a surge in French bond yields relative to German yields and a renewed bout of Eurozone break up fears weighing particularly on the Euro and Eurozone shares but also on global shares as was the case back at the height of the Eurozone crisis in 2011-13.

Fortunately, Macron has been consistently ahead of Le Pen in polling for a second round run-off with the gap on the latest poll average well above 20%. This is far wider than the roughly 4 point polling error in the Brexit result and the 2 point polling error in the Trump-Clinton vote in the US Presidential election.

Source: Bloomberg, AMP Capital

That said, there is still a risk that things could go wrong and lead to a surprise Le Pen victory. A spate of IS terrorist attacks could drive support towards Le Pen (they are likely on Le Pen's side given that they thrive on extremism) or Russia could release hacked information damaging to Macron (via Wikileaks). And while it’s hard to see supporters of Melenchon or the Socialist Hamon supporting Le Pen, some of Fillon's centre-right supporters may switch to Le Pen rather than Macron. Fillon’s endorsement of Macron for the run-off may help minimise this though. Hamon has also endorsed Macron.

Moreover, with a majority of the French in favour of the Euro and highly negative to the far right National Front (partly for historical reasons) and the polling gap in favour of Macron in excess of 20% which is well beyond the standard error, our base case remains that Macron will win on May 7.

This would be a big positive for Eurozone assets. It would reinforce the impression that the populists are not winning in Europe. 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 very poorly. This, in turn, should help reduce Eurozone break up fears. While Italy remains a risk for next year, this all comes at a time when Eurozone assets are relatively cheap globally and Eurozone economic data continues to improve. All of which is consistent with retaining a large exposure to Eurozone shares. 

Source: Bloomberg, AMP Capital

For Australia, the outcome of the first round of the French election is unlikely to have a major impact beyond keeping in place the currently favourable global growth backdrop. That said, there is likely to be a mild relief rally in the Australian share market today and the $A has already had a 0.4% bounce against the $US reflecting its “risk on” status.

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Weekly economic and market update

Monday, April 10, 2017

By Shane Oliver 

Share markets were mixed over the last week, with ongoing nervousness regarding whether US President Donald Trump will pass his pro-business reforms, the Fed signalling a likely start to reducing its balance sheet later this year, and a US missile strike against Syria injecting a bit of uncertainty. US shares fell 0.3%, Eurozone and Australian shares were flat, Japanese shares lost 1.3%, but Chinese shares rose 1.5%. Bond yields and the $A fell, but oil and gold prices rose.

US missile strike

While the US missile strike against Syria in response to a chemical attack on its civilians caused a bit of uncertainty in financial markets, it looks to have been trivial and short lived as has been the case in the past in response to limited military strikes and most terrorist attacks. This is likely to remain the case, as the strike was highly targeted and proportional to the chemical attack and does not signal increased US involvement in Syria. One thing it does tell us though, is that the US is not withdrawing into isolationism under Trump as some feared - and that is a good thing.

Trump's tax agenda

In terms of the policy progress around President Trump: the resurrection of debate around healthcare reform is a negative, in that it could delay tax reform, but a positive in that if it’s successful, it could result in budget savings that make tax reform easier. The change to Senate rules to allow a simple majority of 51 to approve Neil Gorsuch to the Supreme Court will further enrage Democrats and risk more gridlock long term, but is unlikely to have much impact in the short term as the GOP has the 51 Senate votes. Talk of bringing back Glass-Steagall bank regulations won’t go anywhere, as there is no support for such a move in the US Congress. The meeting between Presidents Trump and Xi Jinping looks to have been focussed on getting to know each other, with Trump referring to an “outstanding” relationship with Xi, and that lots of “bad problems will be going away”, but at least the risk of a Trump-driven trade war will remain on the back burner. In short, lots of noise around all this – but as long as Trump’s pro-business agenda remains the focus, investment markets won’t be too fussed.

US Fed signals balance sheet reduction

The US Federal Reserve signals that the third phase of monetary policy normalisation – i.e. balance sheet reduction - is likely to get underway from later this year. The first phase was the tapering and then ending of quantitative easing (or QE) between January and October 2014, the second was the start of interest rate hikes in December 2015, and the third will be letting its balance sheet start to decline, with the minutes from last month's Fed meeting indicating that this is likely to be appropriate from later this year.

The Fed has long signalled that this will be achieved by not reinvesting (or rolling over) the proceeds from maturing bonds in its balance sheet and from the Minutes it looks to favour a phasing down of its reinvesting. The start of the first two phases in moving to more normal monetary policy were associated with corrections in share markets (the “taper tantrum” of mid-2013 and the correction in share markets between May 2015 and February 2016) as investors fretted the Fed will automatically wind back stimulus regardless of the economic impact. So, there is a risk of something similar happening in the months ahead, particularly given that share markets have been vulnerable to a correction for some time. However, there is no reason to get too fussed:

  • First, as the first two phases showed the Fed will not blindly start to run down its balance sheet, but it will be contingent on a continued improvement in the US economy, so it’s likely to be gradual and subject to stopping and starting if needed.
  • Second, balance sheet run down is likely to be a substitute for rate hikes, so if it commences this year it adds to confidence the Fed will only do two rate hikes this year and not three.
  • Finally, while it will involve a net increase in the supply of bonds in the market and so along with further rises in US interest rates points to a resumption of rising bond yields – the Fed won’t be actually selling bonds, so the rise in bond yields is likely to be gradual.
  • The bottom line though is that Fed balance sheet reduction, along with the end of quantitative easing and rate hikes, signal that the Fed’s efforts to support the US economy since the GFC have worked and that it’s appropriate to continue to take it off life support. This is a good thing.   

In contrast to the Fed, the ECB and Bank of Japan are yet to start even the first phase of monetary policy normalisation. Relative monetary policy still points to a strong $US against the Yen and Euro and against the $A with the RBA on hold. 

The French election

The first round of the French presidential election is now only two weeks away on April 23rd. Polls continue to show Le Pen and Macron on around 25% of the vote each. So, it remains likely they will make it through to the run-off on May 7, where polls show Macron leading Le Pen by around 20%. 

RBA on hold

RBA on hold and likely to remain so well into 2018. As widely expected, the RBA left the cash rate on hold at 1.5% for the eighth month in a row. The uncomfortably hot Sydney and Melbourne property markets, along with RBA expectations that GDP growth will return to around 3% and that underlying inflation has bottomed, argue against a rate cut. Against this, high unemployment and underemployment, the too high $A, fragile economic growth and downside risks to underlying inflation all argue against a hike.

Meanwhile, bank rate hikes, regulatory moves to tighten lending standards and hopefully action in the May budget on the capital gains tax discount should help deal with financial stability risks around house prices and household debt, giving the RBA flexibility to set rates in the best interest of the wider economy and not just the Sydney and Melbourne property markets. Our view is that rates have probably bottomed and that the next move will be a hike, but not until the second half of 2018.

The drip feed of negative news flow - bank rate hikes, tightening measures by APRA and ASIC, talk of increased bank capital requirements which will result in more out-of-cycle rate hikes and authorities and commentators warning about the risks - should at least help slow the Sydney and Melbourne property markets. For investors who think that the 10-15% pa average home price gains of the last four-five years are a guide to the future, it's worth having a look at Perth home prices which are where they were ten years ago. Ten years of zero capital growth in Sydney and Melbourne would mean a housing return of just the net rental yield which is 2% or less.  

Major global economic events and implications

US data was mostly solid, with still strong readings for ISM business conditions indexes, strong jobs data apart from payroll employment, a rise in construction spending and a better-than-expected trade deficit. A fall in auto sales and weak payroll employment growth of just 98,000 in March were the main negatives. However, the slowdown in payroll employment looks weather related and with the household employment survey up strongly and unemployment falling to just 4.5% the Fed remains on track to continue normalising monetary policy but with wages growth running at just 2.7% year-on-year, the Fed will remain gradual.

Eurozone retail sales rose more than expected in February and unemployment continued to fall, reaching 9.5%. While unemployment is still high from a growth perspective, it’s the direction that counts and it's down from a high of 12.1% in 2013.

Japanese business conditions surveys showed further improvement in March and consumer sentiment is up - all of which points to reasonable economic growth.

Australian economic events and implications

Australian data highlighted why the RBA needs to remain on hold. On the one hand, March house prices rose strongly, the AIG’s manufacturing and service conditions PMIs were solid, job ads rose, building approvals rebounded and the trade surplus rose to a near record. Against this, February retail sales were soft, building approvals look to have peaked, the near-record trade surplus partly reflected weak imports which is a negative and in any case will fall in the next month or so thanks to Cyclone Debbie’s hit to coal exports and the MI Inflation Gauge showed underlying inflation remaining weak in March.

What to watch over the next week?

In the US, March quarter earnings reports will start to flow, with the consensus looking for a 9.7% gain on a year ago which is likely to be exceeded as expectations have been depressed by a high level of downgrades lately. On the data front, expect small business optimism and job openings (Tuesday) to remain strong and March retail sales (Friday) to perk up a bit reflecting strong jobs and confidence readings. March quarter CPI inflation (Friday) is expected to fall back slightly, but core inflation is expected to come in around 2.3% year-on-year which is around where it’s been for some time.

In China, expect March CPI inflation (Wednesday) to rise to 1.2% year on year after February's surprise fall to 0.8%, but producer price inflation to slow to 7.5% year-on-year (from 7.8%) as positive momentum in commodity prices has faded. Trade data (Thursday) is likely to show a slowing in import growth to 20% year-on-year but a pick-up in export growth to 10% year-on-year. 

In Australia, expect flat housing finance (Monday), continued strength in business conditions according to the NAB business survey (Tuesday), consumer confidence remaining around its long-term average (Wednesday) and a 30,000 bounce in employment (Thursday) in March with unemployment remaining at 5.9%. The housing finance data will be watched closely to see whether the surge in lending to property investors continued in February. The RBA's latest Financial Stability Review is likely to reiterate the Bank's recent concerns regarding financial stability risks flowing from excessive growth in home prices and household debt - but this is likely to be a bit dated given that the regulators have already moved. 

Outlook for markets

Shares remain vulnerable to a short-term pull back as investor sentiment towards them is very bullish and a lot of good news has been factored in which has left them vulnerable to any bad news. But putting short-term uncertainties aside, with valuations remaining okay, global monetary conditions remaining easy and 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. 

With the Australian share market having broken decisively above the 5800 level, it now looks like it’s on its way to a retest of the March/April 2015 intraday highs of just below 6,000.

Still low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds. At present, bond yields are still consolidating after last year’s rise, but a resumption of the bear market is likely at some point in the months ahead seeing a gradual rise in yields. 

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, 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 $A has been range bound between $US0.72 and $US0.78 and this may continue for some time. At some point this year though, the downtrend in the $A from 2011 is likely to resume as the interest rate differential in favour of Australia narrows (as the Fed hikes rates and the RBA holds) and as the Fed eventually moves to reduce its balance sheet and hence narrow measures of US money supply.

Eurozone shares rose 0.2% and the US S&P 500 slipped 0.1% on Friday as investors digested the messy US jobs report (weak headline payrolls but strong details) and the missile attack on Syria. However, the impact on global share markets from the Syrian missile strike was less than the Australian share market had factored in on Friday (where a 0.5% gain in the market was largely wiped out by news of the attack). As a result, ASX 200 futures gained 14 points or 0.2% pointing to a positive start to trade for the Australian share market on Monday.

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