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

Week in review: Trade war threat still remains

Monday, June 18, 2018

Investment markets and key developments over the past week

  • The past week saw mixed share marketsUS shares were flat with strong data offset by worries about a more hawkish Fed and tariffs on Chinese imports, Eurozone shares rose 1.4% as the ECB remained dovish and Italian risks receded a bit and Japanese shares rose 0.7% as the Bank of Japan remained dovish. Chinese shares were not helped by soft economic data and fell 0.7%. However, the Australian share market rose 0.8% helped by a mostly positive global lead and as lower bond yields helped support strong gains in yield sensitive utilities and telcos. Bond yields generally fell as did prices for oil and metals, but iron ore rose. A mildly hawkish Fed and strong US data at the same time as a dovish ECB and Bank of Japan and softer non-US data saw the US dollar rise to its highest since July last year and this saw the $A fall back below $US0.75.
  • Good news on North Korea and Italy, but the trade war threat remains. The Trump/Kim summit was a big deal for world peace and while some critics wanted more no major peace deal has been achieved in a day – that it happened, that there is agreement to work towards the complete denuclearisation of the Korean peninsula, that there will be follow on talks to implement this and that the US will suspend military exercises is the best that could have been hoped for from the summit. It gives investors a bit of peace on this issue for at least a year. Tick for now. On Italy and Itexit worries there was a bit of relief with new Italian Finance Minister Tria saying that there has been no discussion of an Itexit. Budget conflict with the European Commission still lies ahead but our view remains that Italy stays in the Euro. So tick for now.
  • Meanwhile the trade war threat remains with the US announcing its latest list of $50bn of Chinese imports to be subject to a 25% tariff of which $34bn will be implemented on July 6 and the remainder are still subject to further review. And as expected, China immediately announced a proposed list of tariffs on $50bn of imports from the US. No tick here. Just bear in mind though that this should be no surprise to anyone, as it’s what Trump’s May 29 statement said the US would do by June 15, it’s still just another list that has yet to be implemented and if implemented it would cover less than 2% of imports to the US so we would still be a long way from the Smoot-Hawley 20% tariffs on all imports that helped make the Great Depression “great”. 
  • Trump also sees these announcements as a way of pressuring China into action on trade – so more classic Art of the Deal stuff - with US Trade Representative Lighthizer hoping “that this leads to further negotiations” and with the July 6 start date for some of the tariffs still leaving three weeks to do so. Ultimately a negotiated solution is likely – and this is what both the US and China want - but the risks are high and the tariffs could well be implemented before the issue is resolved.
  • Major central banks slowly taking away the punch bowls but it’s very gradual and there is still lots of punch around:
  • The Fed provided no surprises in hiking rates again for the seventh time this cycle but yet again it was a bit more hawkish and the “dots” have moved to four hikes this year. Our view remains four hikes this year and three next and we continue to see US money market expectations as too dovish. This should all mean ongoing upwards pressure on US bond yields but its worth nothing that US rates at 1.75-2% are still far from tight and so we are still a long way from the point where US growth is threatened.

Source: Bloomberg, AMP Capital

  • The ECB made no changes to monetary policy but confirmed that it “anticipates” ending its quantitative easing program in December after further phasing it down to €15bn/month through the December quarter. However, its been tapering its QE program since 2016, its left the door open to extending QE into 2019 if needed (by making its ending “subject to incoming data”), its indicated it will reinvest maturing assets for an “extended period” and that it expects no rate hike until at least mid-2019 and ECB President Draghi’s comments were dovish. It took the Fed more than a year after ending QE before it started rate hikes. With inflation way below target, growth indicators softening a bit lately and uncertainties around Italy a rate hike is unlikely until 2020 at the earliest. So ECB easy money may be getting a bit less easy, but it still looks like remaining easy for a long while yet.
  • Finally, the Bank of Japan remains full steam ahead with its ultra-easy monetary policies. No surprise here with weaker data lately and core inflation falling again.
  • While talk of the ending of ultra-easy monetary policy globally generates periodic excitement in markets and amongst commentators it’s worth noting that its now more than five years since the US “taper tantrum” started it all off – so its been a very gradual process – and I suspect global monetary policy will remain easy for years to come. Just less easy than it was.

Major global economic events and implications

  • US economy accelerating. Small business optimism rose to its second highest ever (with surging worker compensation and profit readings), retail sales growth was very strong in May, industrial production dipped in May but this was due to autos and the New York regional manufacturing conditions index rose further in June, jobless claims remain ultra-low and consumer, producer and import price data show a continuing edging up in inflationary pressures and point to core private consumption deflator inflation (the Fed’s preferred inflation measure) rising to 1.9-2% year on year for May. The Atlanta Fed’s GDPNow growth tracker puts June quarter growth at 4.8%.
  • Eurozone economy still slowing. Eurozone industrial production fell in April consistent with some softening in Eurozone growth – which will present a bit of a threat to the ECB’s plans to end is QE program in December.
  • China slowing too. Chinese data mostly softened suggesting the long awaited mild slowing in growth may be underway. Unemployment edged down in May to 4.8% and home price gains picked up, but industrial production, retail sales, investment and credit growth all slowed. This may reflect noise in monthly data, but it may also be reflecting the impact of deleveraging measures which have hit “shadow banking.” This is broadly consistent with our view that GDP growth will slow to 6.5% this year. But more moves to ease monetary policy are likely to ensure growth doesn’t slow too much.

Australian economic events and implications

  • Australian data was back to being a bit on the softish side. Business confidence slipped a bit in May but remains solid, consumer confidence remains stuck around long term average levels, housing finance continued to slow in April with tighter bank lending standards pointing to more weakness to come and jobs data was a bit soft in May. Employment growth was weaker than expected with full time jobs falling and while unemployment fell slightly this was because of a decline in participation. Meanwhile underemployment rose slightly over the last three months to 8.5% so total labour market underutilisation remains very high at 13.9%.
  • While RBA Governor Lowe reiterated the mantra that the next move in interest rates is likely to be up, he also said any increase “still looks to be some time away” and indicated that to raise rates the RBA is looking for reduced labour market slack, faster wages growth and increased confidence inflation is picking up. At present there is no sign of reduced labour market slack and this is likely to continue to weigh on wages growth. We remain of the view that with trend growth likely to be remain subdued, bank lending standards tightening, Sydney and Melbourne house price falls having further go that the RBA won’t start raising rates to 2020 at the earliest and in the meantime the next move being a cut can’t be ruled out.

What to watch over the next week?

  • Apart from the ongoing issues around trade, the focus in the week ahead will remain on central banks with Fed Chair Powell, ECB President Draghi, BoJ Governor Kuroda and RBA Governor Lowe all participating in a panel discussion in Portugal on Wednesday. It’s doubtful that any of them will say anything new having all just had meetings or made speeches, but no doubt their comments will be watched for any clues on the monetary policy outlook
  • In the US, expect home builder conditions (Monday) to remain strong, housing starts (Tuesday), home sales (Wednesday) and home prices to all rise and the June business conditions PMIs (Friday) to remain strong at around 56-57.
  • Eurozone June business conditions PMIs (Friday) will be watched closely to see whether the recent softening trend continues.
  • The Bank of England (Thursday) is expected to leave monetary policy on hold particularly given recent softer data and ongoing Brexit uncertainty.
  • Japanese core inflation data for May (Friday) is expected to show a further dip to 0.3% year on year (from 0.4% in April) consistent with Tokyo inflation data already released.
  • In Australia, ABS March quarter data is expected to confirm a 1% or so decline in home prices (Tuesday) consistent with already released private sector surveys and population growth data (Thursday) for 2017 is expected to show continued strength of around 1.6% year on year with Victoria the strongest on the back of high immigration levels and interstate migration. The minutes from the RBA’s last board meeting (Tuesday) are likely to confirm that the RBA remains comfortably on hold.

Outlook for markets

  • Volatility in share markets is expected to stay high as US inflation and interest rates move up and as issues around President Trump (trade, Mueller inquiry, etc) continue to impact, but the medium-term trend in share markets is likely to remain up as global growth remains solid helping to drive good earnings growth. We continue to expect the ASX 200 to reach 6300 by end 2018.
  • Low yields and capital losses from rising bond yields are likely to drive low returns from bonds. Australian bonds are likely to outperform global bonds helped by the relatively dovish RBA.
  • Unlisted commercial property and infrastructure are still likely to benefit from the search for yield, but it is waning, and listed variants are vulnerable to rising bond yields.
  • National capital city residential property prices are expected to slow further as the air continues to come out of the Sydney and Melbourne property boom and prices fall by another 4% this year, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms.
  • Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.
  • The $A likely has more downside to around $US0.70 as the gap between the RBA’s cash rate and the US Fed Funds rate pushes further into negative territory as the US economy booms relative to Australia. Solid commodity prices should provide a floor for the $A though in the high $US0.60s.
  • Eurozone shares fell 0.7% on Friday and the US S&P 500 declined 0.1% as President Trump’s latest list of $50bn of Chinese imports to be subject to tariffs keeps trade war risks alive. The soft US lead saw ASX 200 futures close flat on Friday night suggesting a flat start to trade for Australian shares on Monday.

 

Week in review: Turmoil in Italy and US trade

Monday, June 04, 2018

Investment markets and key developments over the past week

  • For the week this left US shares up 0.5%, but Eurozone shares down 1.4%, Japanese and Chinese shares down 1.2% and Australian shares down 0.7%. While bond yields rose late in the week they ended down slightly in most major countries except in Italy. Commodity prices were mixed with copper up slightly but oil and iron ore down. Despite the volatility in markets the $A rose slightly with the $US little changed.
  • Trade war worries back to the fore again with Trump announcing that tariffs and investment restrictions on China will be formalised on June 15 and 30 respectively and start soon thereafter and that US exemptions for the EU, Mexico and Canada to the steel and aluminium tariffs announced earlier this year are ending. These moves are concerning and heighten the risk of a global trade war, but both need to be put in some context. First, the measures regarding China are the same as those flagged on March 22nd which were due to be formalised by May 22nd but were then put on hold after the start of successful negotiations with China two weeks ago. Trump appears to be taking a tough stance again to nullify domestic criticism he has gone too easy on China, but it also looks like a negotiating tactic designed to get more out of China ahead of another round of talks. The risk is that China feels it can no longer trust Trump. But solving this issue was never going to be smooth, it will take time and Trump’s volatile nature along with divisions on the US side will continue to add to noise.
  • Second, the commencement of tariffs on steel and aluminium from the EU, Mexico and Canada is (like all protectionism) dumb economics particularly at a time when the US is already operating at close to full capacity. But it’s worth putting all these tariffs in context: steel & aluminium imports are less than 2% of US imports (and less than that is affected as many countries including Australia are exempted) and $50bn of Chinese imports are also less than 2% of US imports so taken together it’s a non-event compared to the 1929 or 1971 tariff hikes of 20% and 10% respectively that covered most imports. A proportional response is expected on steel and aluminium but it’s only going to have a significant global economic impact if it triggers multiple rounds of tit for tat tariff hikes across a broad range of products.  The bottom line is that while the risks have escalated we are still a long way from a full-blown trade war globally and Trump is likely wary of pushing too hard here for fear of a backlash from US workers who will have to pay more at Walmart and see their jobs go at Harley Davidson, Boeing, etc.
  • Early election averted in Italy with the Five Star Movement and Northern League forming government, but it’s likely to remain messy. The Finance Minister may not be so anti-Euro but the agenda for fiscal expansion and hence the likelihood of conflict with the European Union remains high. As a result, Italian bonds and shares are likely to remain under pressure for a sometime yet as investors fear that the ECB won’t be able to support Italian bonds, the economic outlook deteriorates, and they worry that their investments will fall in value if Italy exits the Euro. Uncertainty about Italy is likely to continue to weigh on the Euro and Eurozone shares and as we saw with the Eurozone debt crisis a few years ago this can also weigh on global and Australian shares at times because it raises concerns about growth in the world’s third largest economic block after the US and China. So Italy at just 1.9% of global GDP can have an outsized impact on markets just like Greece at just 0.3% did during the Grexit crises.
  • However, two things are worth noting. First, ultimately Italy is likely to remain in the Euro because it’s too hard to leave given it would involve a sharp collapse in the value of a “new” Lira, a run on the banks, capital flight and a further sharp rise in Italian bond yields and a majority of Italians support it. But as we saw with Greece and Syriza a few years ago it can take a while (and a sharp rise in Italian bond yields) to get to this point. Second, the risk of contagion to other countries like Spain, Portugal, Ireland and Greece is now low given they are seeing stronger economic conditions, lower unemployment and reduced budget deficits and popular support across for the Euro is high across Eurozone countries at over 70%.
  • Spain is no Italy - the change of government in Spain to one led by the centre left Socialists, does not threaten Spain’s commitment to the Euro. The Socialists are pro-EU and the Euro and given political constraints will honour the Rajoy government’s budget that was recently passed. Even if the new government fails and there are early elections the Citizens Party or Ciudadanos would gain the most and it also supports the Euro. Along with the People’s Party these three pro Euro parties garner two thirds popular support and the eurosceptic Podemos only gets around 17% support. So forget about any “contagion” from Italy to Spain.
  • Trade wars, Itexit fears and the investment cycle. A big debate in the investment world is always about where are we in the investment cycle. This is particularly the case at present in relation to the US economy and share market where the cycle is more mature. A normal cycle would see growth continue at high levels, spare capacity recede and inflation and other signs of excess continue to build driving monetary policy ultimately into tight territory and setting the scene for the next major bear market and economic downswing. However, as we have seen ever since the GFC this has all been a long time coming as various events have slowed the build-up in growth and excesses. Geopolitical shocks such as a trade war or an escalation of worries around an Itexit could have the same impact in cooling growth, pushing bond yields back down and ultimately extending the day of reckoning for the global economic upswing

Major global economic events and implications

  • Another week of strong US data. Consumer confidence remains about as high as it ever gets, personal spending growth was solid in April, home prices are continuing to rise, the ISM manufacturing conditions index rose to an even stronger level in May, construction activity is rising solidly, the goods trade deficit unexpectedly improved in April and labour market data remains strong. May saw another “Goldilocks” jobs report with payrolls up a stronger than expected 223,000 and unemployment falling to 3.8% which is its lowest since 1969 but wages growth only edging up to 2.7% year on year. The April core private final consumption deflator was unchanged at 1.8% year on year but is running at 2% on a 3 and 6-month annualised basis which is right on the Fed’s inflation target. This is all consistent with the Fed continuing to raise interest rates with the next move this month and we still see a total of four hikes this year.
  • Eurozone economic sentiment slipped in May, but it’s still strong. Meanwhile unemployment came in at 8.5% in April which was down from 8.6% in March and May core inflation bounced back to 1.1%yoy. Italian risks may not stop the ECB from starting to taper its quantitative easing program in the December quarter, but it adds to confidence that it will not be raising interest rates until second half next year at the earliest.
  • Japan saw strong labour market data and a rise in consumer confidence but weaker than expected production.
  • Chinese business conditions PMIs for May were flat or rose a bit consistent with continuing solid growth.
  • Indian March quarter GDP growth came in at a strong 7.7%yoy – surpassing China’s growth rate of 6.8%yoy.

Australian economic events and implications

  • Australian economic data was on the soft side with a fall in building approvals, continuing moderate credit growth, a continuing fall in home prices and a softer than expected rise in business investment for the March quarter. Investment plans are showing improvement, but its gradual with investment plans for 2018-19 only up 1.4% on those for 2017-18. At least they are no longer plunging though, so the drag on growth from investment is over.

Source: ABS, AMP Capital

  • Capital city dwelling prices continued to slip in May falling by 0.2% month on month and 1.1% year on year. Prices have now fallen for seven months in a row and Sydney is continuing to lead the way down. Our assessment remains that home prices in Sydney and Melbourne have more downside ahead thanks to tightening bank lending conditions, rising supply, falling capital growth expectations causing buyers to hold back and slowing foreign buying. In the absence of much higher unemployment or higher interest rates, price declines are likely to remain gradual and this is also consistent with auction clearance rates which have slowed but not collapsed. Our expectations are for Sydney and Melbourne prices to fall 6% or so this year, another 5% next year and around 2-3% in 2020. Prices in Perth and Darwin look close to the bottom and moderate growth is expected in other capitals. Overall, Sydney and Melbourne are likely to see a top to bottom fall of around 15% spread out to 2020, but for national average prices the top to bottom fall is likely to be around 5%.
  • The increase in the minimum wage by 3.5% from July will help wages growth, but only a bit. This increase is only fractionally stronger than last years 3.3% rise which helped wages growth tick up from 1.9% to 2.1%. With unemployment and underemployment remaining very high at around 14% its hard to see underlying wages growth picking up much so our guess is that the 3.5% minimum wage increase will just help keep wages growth ticking along at 2.1%. Pumping up minimum wages won’t jump start stronger underlying wages growth because to get that we need to see a much tighter labour market and that needs stronger growth. The risk is that it makes low income workers relatively less attractive further boosting automation and offshoring.

What to watch over the next week?

  • In the US, it will be a relatively quiet week on the data front but expect the May non-manufacturing conditions ISM index (Tuesday) to remain strong at 56-57, job opening and hiring data for April (also Tuesday) to have remained very strong and the trade deficit for April (Wednesday) to improve slightly.
  • Chinese trade data for May (Friday) is expected to show export growth remaining solid at around 10% year on year but import growth slowing back to around 12% yoy. Inflation data will also be released Saturday but should be benign.
  • In Australia, the RBA is expected to leave interest rates on hold for a record 22 months in a row when it meets Tuesday. While the RBA would no doubt like to be raising rates to more normal levels like the Fed is and continues to repeat the mantra that the next move is more likely to be up than down there is currently no case to move rates. Booming infrastructure investment, better non-mining investment, strong export growth and the RBA’s own forecasts for growth and inflation all support the case for an eventual rise in rates but this is counterbalanced by uncertainty around consumer spending, weak wages growth and inflation, tightening bank lending standards and the slowing Sydney and Melbourne property markets. Our view remains that a rate hike is unlikely until 2020 at the earliest and that in the interim a rate cut cannot be ruled out.
  • On the data front in Australia the main focus will be on March quarter GDP growth (Wednesday) which is expected to come in at 0.8% quarter on quarter or 2.7% year on year thanks to a 0.6 percentage point contribution from net exports after several weak quarters and strong public demand offsetting soft growth in consumer spending. In other data expect a 0.1% rise in April retail sales (Monday), continued strength in services conditions PMIs (Tuesday) and a slight fall in the trade surplus (Thursday) to $1.3bn.

Outlook for markets

  • Volatility in share markets is likely to remain high as US inflation and interest rates move up and as issues around President Trump (trade, Mueller inquiry, etc) continue to impact, but the medium-term trend in share markets is likely to remain up as global recession is unlikely and earnings growth remains strong globally and solid in Australia. We continue to expect the ASX 200 to reach 6300 by end 2018.
  • Low yields and capital losses from rising bond yields are likely to drive low returns from bonds. Australian bonds are likely to outperform global bonds helped by the relatively dovish RBA.
  • Unlisted commercial property and infrastructure are still likely to benefit from the search for yield, but it is waning, and listed variants are vulnerable to rising bond yields.
  • National capital city residential property prices are expected to slow further as the air continues to come out of the Sydney and Melbourne property boom and prices fall by another 4% this year, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms.
  • Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.
  • The $A likely has more downside to around $US0.70 as the gap between the RBA’s cash rate and the US Fed Funds rate pushes further into negative territory. Solid commodity prices should provide a floor for the $A though.
  • The formation of a coalition Government in Italy and another Goldilocks jobs report in the US saw Eurozone shares gain 1.1% on Friday and the US S&P 500 also rise by 1.1%. The positive global lead saw ASX 200 futures rise by 34 points or 0.6% pointing to a gain at the open for the Australian share market on Monday.

 

 

 

Week in review: No trade war but still no trade peace

Monday, May 28, 2018

The past week has again seen geopolotical issues dominate with renewed trade worries out of the US, the cancellation and then possible resurrection of the North Korean summit, rising angst around the formation of a populist government in Italy and political uncertainty in Spain. US shares managed a 0.3% gain, but Eurozone shares fell 1.3%, Japanese shares fell 2.1%, Chinese shares lost 2.2% and Australian shares fell 0.9%. Bond yields continued to blow out in Italy but declined elsewhere helped by safe haven demand. Commodity prices were mixed with gold & metals up but iron ore down and oil down as Saudi Arabia said OPEC and Russia will likely raise oil production. The $A managed a small rise despite a further rise in the $US.

No trade war, but still a long way from trade peace. Trump has been blowing all over the place on US-China trade talks in the last two weeks – no he doesn’t expect much from them, yes the benefits of the initial talks are massive, and no he’s not really pleased with the outcome. But this is just classic Trump who says what he thinks at the time, wants to appeal to his base and will say extreme things in order to get what he wants in negotiations. The good news though is that negotiations between the US and China are off to a good start and China is keen on reducing tensions with the US and the US has put the start of tariffs (due from May 22) on hold. But there is still a long way to go – a problem that took decades to build won’t be negotiated away in just a few weeks – and if there is not enough progress the threat of tariffs remains. But our view remains that ultimately a full-blown US-China trade war will be averted. In the meantime of course, the NAFTA renegotiation has a way to go, Trump has ordered a consideration of imposing tariffs on US auto imports and the EU’s exemption from US steel and aluminium tariffs will expire again on June 1 (but is likely to be extended). Given that 29% of US auto imports come from Mexico and 19% from Canada the latest move is designed to pressure them on NAFTA. But it will also impact Japan, Korea and Germany. But it’s all about Trump posturing around negotiations and like the steel and aluminium tariffs any impact is likely to be significantly watered down.

June 12 summit between Trump and Kim Jong-Un killed by the Libyan model, or maybe not?. With North Korea having flouted agreements and gone hot and cold for decades it was always debatable as to whether much would come of the summit anyway. But not having the summit doesn’t mean military conflict is on the way. The North Korean regime knows that it will get annihilated if it does anything and the US knows that a pre-emptive strike will result in mass casualties in South Korea. And in any case having cancelled the summit on Thursday, Trump did another backflip on Friday saying “we are talking to them now” and it could still be on for June 12th!

Turn down the noise on Trump. There is no denying that Trump’s comments add to market volatility and the risks around Trump are greater this year than last (with tax reform and deregulation behind us, the mid-terms approaching and the Mueller inquiry getting closer to Trump). However, much of what he says is just open mouth thought bubbles, bluster and posturing. Yes, he should be taken seriously, but not literally. For investors its best to focus on the investment fundamentals around growth, profits, interest rates, etc, and to turn down the noise on Trump.

Back to the Eurozone crisis? Investors are right to worry about a populist Government in Italy – its proposed fiscal policies will blow the Italian budget deficit through the EU limit of 3% of GDP leading to conflict with the EU, sanctions, the ECB excluding it from its bond buying program and ratings agency downgrades. However, anticipation of this and the risk that 5SM and the Northern League return to their policy of wanting Italy to exit the Euro is already pushing Italian bond yields sharply higher as bond holders try to protect against redenomination risk or default. So far this month Italian 10-year bond yields have been pushed up by 66 basis points to 2.44%. This is a long way from the 2011 crisis highs around 7%, but the more yields rise from here the more it will hit Italian banks, borrowing costs and hence the Italian economy. Ultimately the Italian Government will have to back down as a result and it will all look a bit like what happened with Syriza in Greece, with Italy remaining in the Euro (because it’s too costly to leave). But in the process, it will be bad news for Italian bonds and shares, will act as a drag on the Euro and will cause occasional bouts of volatility in share market (including Australian shares - recall the volatility around Grexit). The risk of a move by Italy to exit the Euro triggering contagion to the rest of the Eurozone though is low as countries like Spain, Portugal and Ireland are stronger than in the crisis years and popular support for the Euro is high. Political uncertainty in Spain following a corruption scandal that may see a new election doesn’t help, but does not threaten Spain’s commitment to the Euro.  

Time to remain alert but not alarmed regarding Chinese debt. This issue has been wheeled out regularly for years and the RBA had another go at it in the last week. Yes its gone up too fast, yes the growth of “shadow banking” has been an issue, yes some of the debt will turn bad and so yes it’s a risk. But there is nothing new here. China is different to most countries that get into debt problems in that it borrows from itself (so there’s no pesky foreigners to cause an FX crisis), much of the rise in debt owes to corporate debt that’s partly connected to fiscal policy (and so the odds of government bailout are high) and the key driver of the rise in debt is that China saves around 46% of GDP and much of this is recycled through the banks where it’s called debt. So unlike other countries with debt problems China needs to save less and turn more of its savings into equity than debt. The Chinese authorities have long been aware of the issue and have been working to slow debt growth. So yes, keep an eye on it but there is no need for alarm.

Major global economic events and implications

US data remains solid. While home sales slipped in April, home prices continue to rise, underlying durable goods orders rose solidly in April and the Markit business conditions PMIs rose further in May. Meanwhile the minutes from the Fed’s last meeting didn’t tell us much that we didn’t know: the meeting leant to the dovish side with Fed upbeat on the economy and on track for another hike next month, but tolerant of a temporary inflation overshoot of 2% as its consistent with the  symmetric inflation target so just because inflation goes above 2% doesn’t mean it will slam on the brakes. However, its comments are consistent with three more rate hikes this year (starting in June) whereas the money market is still not there yet.

Eurozone business conditions PMIs fell again in May. While more public holidays than normal may have played a role and they are still strong their decline relative to US PMIs is a big driver of why the Euro is now falling against the US dollar.

Japan’s manufacturing PMI also fell in May but remains consistent with moderate growth. A further fall in Tokyo’s core inflation to just 0.2% yoy highlights yet again that the BoJ is along way from being able to exit easy money. Which in turn is negative for the Yen (barring bouts of safe haven demand).

Australian economic events and implications

Australian economic data was on the soft side over the last week with skilled job vacancies falling and construction activity coming in virtually flat in the March quarter. Public construction is rising strongly as the infrastructure boom rolls on, but this is being offset by weakness in private sector construction driven by non-residential building. The latter suggests a soft input into March quarter GDP numbers to be released in early June.

What to watch over the next week?

In the US, it will be a big week on the data front with inflation and jobs data the focus. The core personal consumption deflator (Thursday) is expected to show inflation remaining at 1.9% year on year or May, just below the Fed’s target. Labour market data (Friday) is expected to show a solid 185,000 rise in payrolls, unemployment holding at 3.9% and wages growth edging up to 2.7% year on year. In other data expect: consumer confidence (Tuesday) to remain strong; May personal spending (Thursday) to have remained solid; pending home sales (also Thursday) to rise around 1%; and the May manufacturing ISM (Friday) to have remained strong at around 57-58. All of which, supports another Fed rate hike next month.

Eurozone data to be released Thursday is likely to show a unemployment remaining at 8.5% and a slight rise in core inflation to 0.8% year on year (after its April slump to 0.7%). With the latter remaining well below target an early exit from ultra-easy ECB monetary policy will remain unlikely.

Japanese labour market data (Tuesday) and industrial production (Thursday) will be released.

Chinese business conditions PMIs are likely to continue to average around recent levels consistent with solid growth.

In Australia, March quarter business investment data to be released on Thursday will be the highlight. Expect to see a 0.8% bounce in March quarter investment with investment intentions data showing ongoing signs that mining investment is getting near the bottom and that non-mining investment is edging up. Meanwhile in other data expect to see a 1% decline in building approvals (Wednesday), continuing moderate growth in credit (Thursday) and CoreLogic data for May (Friday) showing another modest fall in May home prices led by Sydney.

Source: Domain, AMP Capital.

Outlook for markets

Volatility in share markets is likely to remain high as US inflation and interest rates move up and as issues around President Trump (trade, Mueller inquiry, etc) continue to impact, but the medium-term trend in share markets is likely to remain up as global recession is unlikely and earnings growth remains strong globally and solid in Australia. We continue to expect the ASX 200 to reach 6300 by end 2018.

Low yields and capital losses from rising bond yields are likely to drive low returns from bonds. Australian bonds are likely to outperform global bonds helped by the relatively dovish RBA.

Unlisted commercial property and infrastructure are still likely to benefit from the search for yield, but it is waning, and listed variants are vulnerable to rising bond yields.

National capital city residential property prices are expected to slow further as the air continues to come out of the Sydney and Melbourne property boom and prices fall by another 5% this year, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.

The $A likely has more downside to around $US0.70 as the gap between the RBA’s cash rate and the US Fed Funds rate pushes further into negative territory. Solid commodity prices should provide a floor for the $A though.

 

Week in review: US-China trade and rising oil

Monday, May 21, 2018

Investment markets and key developments over the past week:

Global share markets were mixed last week with Japanese and Chinese shares up 0.8% and Australian shares up 0.5%, but Eurozone shares flat weighed down by a fall in Italian shares and US shares down 0.5% on the back of rising bond yields and geopolitical worries. Bond yields mostly rose led by strong data out of the US and the spread between Italian and German bonds widened as investors worried about a populist government in Italy. Oil prices rose but gold, copper and iron ore prices fell. A further rise in the $US weighed on the $A.

US-China trade talks with China’s Vice Premier Liu He have proved “constructive” with China pledging to reduce its trade surplus with the US, buy more US goods and services and toughen intellectual property laws. A trade war has likely been averted. This is very positive. There is a long way to go to work out the details but it’s clear that the US and China have started a constructive process to resolve their differences and have agreed to stop “slapping tariffs” on each other. The risk of a growth debilitating trade war between the US and China has now subsided substantially. The US tariffs on Chinese imports that were due to be finalised by May 21 will almost certainly be put on hold. Both sides can claim victory here – President Trump can claim that his strategy of putting maximum pressure on China regarding trade and intellectual property is working and China will benefit by putting its trade relationship with the US onto a more sustainable footing. This news is positive for global share markets as investors had been fretting ahead of the May 21 deadline. Shares in US companies with significant exposure to exports to China will be key beneficiaries. But it’s also a big positive across Asia and for Australian resources stocks given supply chain linkages to Chinese companies that export to the US. There is a long way to go in terms of specifics, but this development adds to confidence a negotiated solution will be found to the US-China trade dispute and that a trade war will be averted.

Investors finally awaking to the risks around a populist Five Star Movement and Northern League government in Italy. While they are yet to agree a Prime Minister, they are proposing big tax cuts, a basic income, a roll back of pension reforms and a review of EU budget rules. The resultant budget deficit blow out will create tensions with the rest of the EU and put upwards pressure on Italian bond yields with NL leader Matteo Salvini naively bragging that “the spread [between Italian and German bond yields] is going up – do you remember the spread?”. It seems investors do and the spread between Italian & German bond yields rose by 0.37% over the last week and this is now weighing on Italian shares which fell 2.9% over the last week. Market & economic realities may eventually force 5SM and NL to water down their policies in government – which may explain why the leader of neither wants to be prime minister! In some ways this has echoes of the experience of Syriza in Greece that promised extreme populist policies but became just another centrist European political party. An Itexit is not an imminent threat and the risk of contagion to the rest of the Eurozone is far less than it was when Grexit was talked about as other vulnerable countries like Spain are now in much better shape and popular support for the Euro is solid. But a 5SM/NL Government will be bad for Italian assets and poses some risks for the Euro.

At least another spread is falling & that’s the US Libor-OIS rate spread (or the interbank lending rate less the expected Fed Funds rate) and the bank bill rate less expected cash rate spread in Australia has followed. Such spreads have fallen by 0.15% or so over the last few weeks – this is taking pressure off bank funding costs thereby reducing the risk that Australian mortgage rates will rise in compensation. However, a threat to mortgage rates from rising global bond yields is building.

Rising oil prices flowing through to petrol prices and cutting into spending power. Reflecting strong global demand, falling inventory levels and the threat to the supply of Iranian oil, global oil prices have risen around 45% over the last year and this has driven a sharp rise in Australian petrol prices from around $1.25/litre to around $1.45/litre. The lag from higher oil prices to higher petrol prices suggest Australian petrol prices may rise another 3-4 cents/litre in the next week or so.

Source: Bloomberg, AMP Capital

Naturally the rise in petrol prices feeds directly into inflation, but the indirect impact is likely to be muted in Australia’s case as constrained consumer spending in the face of soft wages growth is making it hard for businesses to pass on cost increases. The weekly petrol bill for a typical Australian household is already up $8 over the last year & up $13 since its 2016 low so it will further constrain consumer spending power.

Source: Bloomberg, AMP Capital

Major global economic events and implications

US data remains strong. Housing starts fell, but strength in homebuilder conditions points to a continuing rising trend and April retail sales, industrial production, May manufacturing conditions in the New York and Philadelphia regions and the leading index were all strong. The prices received component of the Philadelphia survey is at its highest since 1989 pointing to higher inflation. Our view remains the Fed will hike three more times this year and the money market is gradually coming around to this view…all of which means more upside for US 10-year bond yields. They broke decisively above 3% over the last week for the first time since 2011 and, while negative sentiment towards them suggests the risk of short term decline in yields, they look to be heading to 3.5% by year end.

No early exit from easy money in Japan. The Japanese economy went backwards in the March quarter for the first time since 2015 and core inflation slowed to just 0.4%yoy. While business conditions surveys point to a rebound in growth, falling and way below target inflation confirms that the BoJ won’t be rushing to the exits from easy money any time soon.

Chinese data was a mixed bag in April with stronger growth in industrial production and a fall in unemployment but slower growth in retail sales and investment. Overall its suggests continuing solid growth, but some slowing in domestic demand.

Australian economic events and implications

Slowing jobs growth and still weak wages growth. While April saw a solid gain in employment with full time jobs leading the charge as they have over the last year it was not enough to absorb new entrants to the workforce and so unemployment edged up to 5.6%. Continuing high levels of unemployment and underemployment suggest that wages growth which remained just 2.1% year on year in the March quarter will remain subdued for some time yet. Yeah, I know that wages including bonuses and hours worked look stronger on an annual basis, but both are very noisy and look affected by base effects. Meanwhile, it’s a bit unclear whether the Budget provided a boost to consumer confidence with the ANZ Roy Morgan survey showing a small rise but the Westpac/MI survey showing a small fall. Whatever the impact was it looks pretty small which is understandable given the boost to low and middle-income earners averages out at around $10 a week and won’t be received until after June next year. This is all consistent with the RBA remaining on hold for a lot longer. We don’t see a rate hike until 2020 at the earliest and still can’t rule out a rate cut.   

What to watch over the next week?

In the US, the focus will be back on trade and the Fed. Monday is the deadline for finalising the list of Chinese products to be subject to tariffs and its also the deadline for the US Treasury to propose restrictions on Chinese investment in the US. Meanwhile the minutes from the last Fed meeting (Wednesday) and a speech by Fed Chair Powell (Friday) are likely to confirm an upbeat view on the US economy and inflation and that it remains on track for more interest rate hikes with the next move in June. They are also likely to push the financial market closer to factoring in another three hikes this year (from expecting just two). On the data front expect May business conditions PMIs (Wednesday) to remain solid at around 55, home sales (due Wednesday and Thursday) to fall back after solid gains in March, home prices (Thursday) to show further gains and durable goods orders (Friday) to rise.

Eurozone business conditions PMIs (Wednesday) for May will be watched for a stabilisation around a still solid 55 after seeing falls from highs earlier this year.

In Australia expect a 0.5% rise in March quarter construction activity (Wednesday) after a very weak December quarter. Skilled vacancy data will also be released and a speech by RBA Governor Lowe (Wednesday) are likely to affirm that the RBA remains comfortably on hold.

Outlook for markets

Volatility in share markets is likely to remain high as US inflation and interest rates move up and as issues around President Trump (trade, Mueller inquiry, etc) continue to impact ahead of the US mid-term elections in November, but the medium-term trend in share markets is likely to remain up as global recession is unlikely and earnings growth remains strong globally and solid in Australia. We continue to expect the ASX 200 to reach 6300 by end 2018, and with the ASX 200 now at 6120 it now looks a lot more believable.

Low yields and capital losses from rising bond yields are likely to drive low returns from bonds. Australian bonds are likely to outperform global bonds helped by the relatively dovish RBA.

Unlisted commercial property and infrastructure are still likely to benefit from the search for yield by investors, but it is waning, and listed variants are vulnerable to rising bond yields.

National capital city residential property prices are expected to slow further as the air continues to come out of the Sydney and Melbourne property boom and prices fall by another 5% this year, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.

The $A likely has more downside to around $US0.70 as the gap between the RBA’s cash rate and the US Fed Funds rate pushes further into negative territory. Solid commodity prices should provide a floor for the $A though.

 

 

Week in review: Rising share markets and the Federal Budget

Monday, May 14, 2018

 

Investment markets and key developments over the past week

  • Global share markets rose over the last week helped by another Goldilocks combination of good economic data, strong profits and benign US inflation. This was despite the US withdrawal from the Iran nuclear deal which pushed up oil prices. For the week, US shares rose 2.4%, Eurozone shares gained 0.7%, Japanese shares rose 1.3% and Chinese shares rose 4%. The positive global lead pushed Australian shares up by 0.9% despite weak retail sales and little short-term stimulus from the Budget. Bond yields were little changed, except in Italy where they rose as populist parties are close to forming a government. Metal prices and the iron ore price rose. The US dollar was pretty much unchanged as was the Australian dollar despite a mid-week fall below $US0.75.
  • Geopolitics: the good, the bad (but possibly okay) and the ugly. The good is of course North Korea which continues to move in a positive direction with President Trump to meet North Korea’s Kim on June 12 in Singapore. The bad is the US/China trade skirmish but the noise around it is okay with President Trump and President Xi having a phone call and a trip to the US by Vice Premier Liu He soon to continue the negotiations on trade. Don’t expect a quick resolution but they are still talking and the incentives remain strong to find a negotiated solution. The ugly is Trump’s confirmation that the US will withdraw from the Iran nuclear accord and reinstate sanctions. It’s ugly because it threatens around 0.7 million barrels a day of Iranian oil exports at a time when the global oil market has tightened, it may see Iran cause more trouble in the Middle East and develop nuclear weapons and it threatens the relationship between the US and its allies notably France and Germany that may stick to the accord (and possibly compensate any of their companies that are adversely affected by US sanctions). The oil price has already moved up so the risks may be factored in. And of course, there is a way to go yet. The US sanctions on Iran and companies that deal with it won’t kick in until after a 90-180 day wind down period. And Trump’s approach as with many things looks like a negotiating ploy to get a better deal. So the Iran nuclear deal is not necessarily over yet.
  • Meanwhile, over in Italy the populist leftist Five Star Movement and populist far right Northern League look to close to forming government. This was the worst possible scenario after the inconclusive March election given both parties background of Euro scepticism and support for irrational economic policies. While its marginally negative for the Euro it’s not an immediate threat, but it will slow a Macron led move to a more integrated Eurozone. And for Italy it risks a renewed deterioration in the budget deficit and an undoing of structural reforms which is negative for Italian shares and bonds. That said, the more extreme 5SM and League policies are likely to be softened down a bit in government and in any case politics is often a mess in Italy so what’s new.       
  • Mahathir returns as PM in Malaysia – now that’s something! The uncertainty could negatively impact Malaysia’s growth in the short term and hence its share market but it’s a long term positive for the country. The 61-year rule of PM Najib’s coalition (which was led by Mahathir between 1981 and 2003) is over and Malaysia looks like it’s going back to what should have happened 20 years ago with Anwar to succeed Mahathir. Will have to look up what recalcitrant means again!
  • The Australian 2018-19 Federal Budget proved surprisingly responsible for a pre-election budget with stronger revenue used to drive budget repair in the short term. If the Treasurer was playing Santa he was a bit stingy. Tax cuts and even more infrastructure projects were the main goodies but the immediate tax cuts are just $10 a week for low to middle earners and won’t be accessed until after June next year and the overall fiscal stimulus in the year ahead is basically zero, which is another reason why the RBA will remain on hold. (While Opposition leader Bill shorten indicated that a Labor Government would increase this to around $18 a week if Labor wins it still won’t be accessed until after June next year.) Rather the big hoped for gains come next decade when the budget is projected to generate larger surpluses and the Government is promising to hand some of this back as tax cuts to stop revenue as a share of GDP rising above historical norms.  Based on current projections this will allow tax cuts starting at around $10bn a year in four or five years’ time – see the next chart. Of course, this all assumes that the Government is re-elected and that revenue grows by around 5.5% pa over the next four years, which are big ifs! A key risk here is the Government’s assumption that wage growth will rise back to 3.5%, which looks a bit optimistic. Nevertheless it does make sense that tax revenue will be capped as a share of GDP around previous high levels and bracket creep returned to tax payers.  The Budget also highlights the starker than normal choice faced by Australians running into the next election between a higher taxing/bigger government offered by Labor and a lower taxing/smaller government offered by the Coalition.

Source: Australian Treasury, AMP Capital

Major global economic events and implications

  • US data remains strong with small business confidence and job vacancies remaining very strong, but inflation is only moving higher gradually. Consumer price inflation rose 0.2% month on month or 2.5% year on year in April, but despite a 3% rise in gasoline prices this was less than expected as core inflation was weaker than expected and unchanged at 2.1% year on year. Core producer price inflation remains in an uptrend but edged down a notch in April. So while inflation is continuing to trend up its only happening slowly. So Goldilocks continues. Strong growth and continuing labour market tightness with jobless claims continuing to fall will keep the Fed normalising, but for now it can remain gradual, with the next hike still on track for June. The US March quarter earnings reporting season is now 90% done, with 76% beating on profits, 73% beating on sales and and earnings up 24% on a year ago. Strength has been broad based but the strongest sectors for earnings growth have been energy, technology, financials and materials.
  • The Bank of England left rates on hold as expected, but despite recent softer data still sees a case to raise rate again this year.
  • Chinese data trade data remains consistent with continuing solid growth with export growth rebounding to 12.9% year on year in April and import growth rising to 21.5%. Meanwhile CPI inflation fell to 1.8% joy from 2.1% but with core inflation running along at 2%. So nothing to get excited about here.

Australian economic events and implications

  • Australian data was mixed with very strong readings for business conditions and to a lesser degree business confidence according to the April NAB business survey but weaker than expected March retail sales highlighting the ongoing divergence between the business and household sectors as low wages growth is good for the former (at least for a while) but bad for the latter. Retail sales were flat in March and March quarter volume growth slowed to just 0.2%. Strong net exports should make up for the implied softness in consumer spending in terms of March quarter GDP growth, but the downside risks to consumer spending remain with weak wages growth, high underemployment and now falling home prices in Sydney and Melbourne and the Budget not providing much short term support to households.

What to watch over the next week?

  • In the US, expect April retail sales growth (Tuesday) to remain strong, the NAHB home builder’s conditions index (also Tuesday) to rise slightly to a strong reading of 70, housing starts to be flat but industrial production to rise solidly (both Thursday) and the New York and Philadelphia regional manufacturing conditions indexes to be solid.
  • Japanese March quarter GDP (Wednesday) is expected to decline slightly by 0.1% quarter on quarter, reflecting soft consumer spending and core inflation for April (Friday) is expected to remain weak and well below target at 0.5% year on year.
  • Chinese April activity data is expected to show a rise in industrial production to 6.3% year on year, retail sales growth remaining around 10% and fixed asset investment remaining around 7.5%.
  • In Australia, the minutes from the last RBA Board meeting (Tuesday) are expected to repeat the message that the Bank is comfortably on hold, wages growth (Wednesday) is expected to remain unchanged at 2.1% year on year, consumer confidence (also Wednesday) will be watched closely for a post Budget bounce and April employment (Thursday) is likely to show a 10,000 gain but with unemployment remaining unchanged at 5.5%.

Outlook for markets

  • Volatility in share markets is likely to remain high as US inflation and interest rates move up and as issues around President Trump (trade, Mueller inquiry, etc) continue to impact ahead of the US mid-term elections in November, but the medium-term trend in share markets is likely to remain up as global recession is unlikely and earnings growth remains strong globally and solid in Australia. We continue to expect the ASX 200 to reach 6300 by end 2018, and with the ASX 200 now at 6120 it now looks a lot more believable.
  • Low yields and capital losses from rising bond yields are likely to drive low returns from bonds. Australian bonds are likely to outperform global bonds helped by the relatively dovish RBA.
  • Unlisted commercial property and infrastructure are still likely to benefit from the search for yield by investors, but it is waning, and listed variants remain vulnerable to rising bond yields.
  • National capital city residential property prices are expected to slow further as the air continues to come out of the Sydney and Melbourne property boom and prices fall by another 5% this year, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms.
  • Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.
  • The $A likely has more downside to around $US0.70 as the gap between the RBA’s cash rate and the US Fed Funds rate pushes further into negative territory. Solid commodity prices should provide a floor for the $A though.
  • Eurozone shares were flat on Friday, but the US S&P 500 gained 0.2% helped by health care stocks as President Trump’s plans on drug prices were seen as posing little short term threat to drug company profits. Reflecting the positive US lead, ASX 200 futures rose 4 points or 0.1% pointing to a slightly positive start to trade for the Australian share market on Monday.

 

 

 

Week in review: 'Goldilocks' jobs report and Australian data

Monday, May 07, 2018

Despite a 1.3% rally on Friday after another “Goldilocks” jobs report, US shares fell 0.2% over the last week. Meanwhile, other share markets fared better over the week, with Japanese shares flat, Eurozone shares up 0.9%, Chinese shares up 0.5% and Australian shares up 1.8%. Bond yields were flat to down. The oil price rose to its highest in 3 years as worries about the return of sanctions on Iran continue to build, but the $US continued to rise, and this weighed on the $A.

Why have Australian shares rebounded? From their early April low Australian shares are up 5.5% and have been helped by reasonable earnings news from Australian companies, solid commodity prices, a fall in the Australian dollar which makes Australian companies more competitive and some fading in trade war fears. But its not just the Australian share market. Eurozone and Japanese shares have had even stronger rebounds from their lows helped by a fall in their currencies. But the rebound in the $US has constrained the US share market.

Geopolitical risks heating up again, but so far so good. May is going to be a big month on the geopolitical front with various US allies’ exemptions to the steel and aluminium tariffs expiring on May 1, the US deadline to fix the Iran nuclear deal expiring on May 12, the public consultation period for tariffs on China due to expire on May 21 and the US Treasury Secretary due to report on proposed restrictions on Chinese investment in the US by May 21. So far so good with the US reaching deals with Australia, Argentina and Brazil on the steel and aluminium tariffs and extending the exemption for Canada, Mexico and the EU until June 1. Negotiations between the US and China have also started on trade, but it was no surprise that the initial two-day negotiation ended without resolution of key issues. A disagreement over trade practices that has built up over more than two decades will take more than two days to resolve. But at least they have shared views and agreed to keep talking.

US heavy handed demands of China look like an ambit claim. Again, classic Art of the Deal stuff. A negotiated solution remains most likely, but it will take time with a lot of posturing and near-death moments along the way. Ultimately a deal will likely be reached – that’s been the whole point of the US threats and China is open to negotiation – but it likely won’t be resolved until after May 21 and so we may see a brief start up to tariffs or a delay to their start up if negotiations are going quickly. On the Iran nuclear deal, its likely Trump will not waive trade sanctions against Iran – this will mean that around 0.7million barrels a day of Iranian oil exports will be lost to the market (against total global production of around 100mbd) which could result in further upwards pressure on oil prices. But its likely to be minimal as oil prices have already moved up in anticipation. Finally, risks around the Mueller inquiry are continuing to hot up. All of which points to ongoing volatility in markets.

There were no surprises from the Fed which remained on hold but remains on track for more hikes. The Fed is upbeat on growth and recognises that inflation is close to its 2% target and will soon run above it. Its new reference to the inflation target being “symmetric” indicates it won’t slam on the brakes just because inflation is above 2%. But it remains on track for more “gradual” rate hikes. We expect three more hikes this year with the next move to come next month at which point the “dot plot” will move up to three more hikes this year too.

There were also no surprises from the Reserve Bank of Australia which also left rates on hold – for a record 21 months and is set to leave them on hold for much longer. While the global backdrop, business conditions, non-mining investment and infrastructure activity are positive and will lead to some acceleration in growth, uncertainty remains around the outlook for consumer spending, household debt is high, banks are tightening lending standards, wage growth and inflation remain low and will pick only gradually and house prices are falling. As a result, the RBA is likely to remain on hold for a long time yet and we don’t see a rate hike until 2020 at the earliest. While the RBA’s latest Statement on Monetary Policy revised up slightly its underlying inflation forecast for this year to 2% and revised up its unemployment forecast to 5.5% the moves are not enough to change the interest rate outlook. It still doesn’t see inflation getting back to the mid-point of the 2 to 3% target over the two years of its forecast horizon and we remain of the view that its forecasts for 3.25% growth are too optimistic.

The 2018 Australian Federal Budget to be handed down on Tuesday 8th May will be a pre-election budget made possible by a revenue windfall. A big improvement in in the underlying budget position on the back of increased corporate tax revenue, strong employment growth and lower spending is expected to see the deficit for this financial year fall to $17bn from the $29bn projected in last year’s Budget. This would allow the projected return to surplus to be brought forward a year to 2019-20 but the Government is likely to “spend” much of the revenue windfall as a pre-election sweetener and leave the return to surplus in place for 2020-21. The key elements of this pre-election budget stimulus - which will amount to around $7-8bn a year or 0.3% of GDP - are likely to be personal tax cuts for low and middle-income earners possibly starting as early as July this year but more likely in July 2019, the dropping of the 0.5% increase in the Medicare levy, more infrastructure projects and maybe some increase in health spending. Financial sector regulation may also get a boost in view of the Royal Commission. And the Government may announce a cut to its immigration intake. Key Budget numbers for 2018-19 are expected to be: a Budget deficit of $13bn (assuming the tax cuts kick in from July 2019), real GDP growth of 3%, inflation of 2.25%, wages growth of 2.5% and unemployment of 5.5%.

Source: Commonwealth Treasury, AMP Capital

The upside of the Australian Government’s Budget strategy is that consumers will be given a shot in the arm at a time of soft wages growth, falling home prices in Sydney and Melbourne and tightening bank lending standards. And the budget stimulus of around 0.3% of GDP will be nowhere near the 2% of GDP seen recently in the US.  The downside is that we will still be seeing a record 11 or 12 years of budget deficits with nothing put aside for the next rainy day and there is a risk that the revenue surprise seen lately will prove ephemeral if global growth is threatened and/or employment slows.

Major global economic events and implications

US data was mostly strong. Construction activity fell in March and the ISM business conditions indexes slipped. However, the ISM indexes remain very strong, personal spending rose solidly in March after a soft patch, pending home sales rose, the trade deficit narrowed in March and labour market indicators remain strong. It was another “Goldilocks” jobs report for April with still solid jobs growth and benign wages growth of 2.6% year on year. However, the fall in unemployment to just 3.9% highlights that the labour market is continuing to tighten and that wages growth will soon push higher. The core private consumption deflator rose to 1.9% year on year in March and has risen at an annual pace of 2.3% over the last six months. It looks like its going to be at 2% faster than the Fed was forecasting. US March quarter earnings results are now 80% done, with 77% beating on profits and earnings running up 24% on a year ago.

Eurozone GDP growth slowed to 0.4% in the March quarter or 2.5% year on year and April core inflation slowed to just 0.7%yoy (from 1%yoy). While we expect growth to remain around 2.5% and the fall in core inflation should prove temporary, the ECB is likely to remain in wait and see mode.

Japanese PMIs rose in April pointing to stronger GDP growth.

Chinese business conditions PMIs were little changed in April suggesting that economic growth is continuing to hold up well.

Australian economic events and implications

Australian data was a bit better than expected. Building approvals rose more than expected in March, April business conditions PMIs remain strong and the trade surplus was much stronger than expected with net exports likely to provide a solid boost to March quarter GDP growth and business credit growth picked up. But against this home prices continued to fall in April and new home sales continue to fall. The tightening in bank lending standards was highlighted by ANZ CEO Shayne Elliot who said it “…will probably make it harder for people to be successful in their [loan] applications. It is more likely we will say no when in the past on balance we would have said yes.”

What to watch over the next week?

In the US, expect to see continuing strength in small business confidence and job openings (Tuesday) and a further lift in annual core CPI inflation to 2.2% (Thursday).

Chinese data for April is expected to show export growth bouncing back to around 8% year on year (after Lunar New Year holiday distortions drop out) and import growth slowing to 13%yoy (both Tuesday), CPI inflation Thursday) falling further to 1.9%yoy and credit growth remaining solid.

In Australia, the main focus will be Tuesday’s Budget, but expect the April NAB business survey (Monday) to show that business conditions remain reasonably solid, March retail sales (Tuesday) to show modest growth of 0.2% in the month and real growth of 0.4% for the March quarter thanks to weak retail prices and housing finance (Friday) to remain soft.

Outlook for markets

Volatility in share markets is likely to remain high as US inflation and interest rates move up and as issues around President Trump (trade, Mueller inquiry, etc) continue to impact ahead of the US mid-term elections in November, but the medium-term trend in share markets is likely to remain up as global recession is unlikely and earnings growth remains strong globally and solid in Australia. We continue to expect the ASX 200 to reach 6300 by end 2018.

Low yields and capital losses from rising bond yields are likely to drive low returns from bonds. Australian bonds are likely to outperform global bonds helped by the relatively dovish RBA.

Unlisted commercial property and infrastructure are still likely to benefit from the search for yield by investors, but it is waning, and listed variants remain vulnerable to rising bond yields.

National capital city residential property prices are expected to slow further as the air continues to come out of the Sydney and Melbourne property boom and prices fall by another 5% this year, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.

The $A is short term oversold and due for a bounce, but it likely has more downside to around $US0.70 as the gap between the RBA’s cash rate and the US Fed Funds rate pushes further into negative territory. Solid commodity prices should provide a floor for the $A though.

 

Weekly economic update: Strong US data and geopolitical news

Monday, April 30, 2018

Shares were flat to up over the last week. Eurozone shares rose 0.5% and Japanese and Australian shares rose 1.4% but US shares were flat despite good earnings results and Chinese shares fell 0.1%. Despite a mid-week spike higher, bond yields were flat in the US, down slightly in Europe on some soft country GDP data and up slightly in Australia. The US dollar continued its recovery, and this weighed on commodity prices and the Australian dollar.

More good news on the geopolitical front with: US Treasury Secretary Mnuchin going to China to negotiate on trade in what will likely be a long process but one that will ultimately head of a full on China-US trade war; French President Macron proposing a renegotiation of the Iran nuclear deal buying a bit of time to head off the US threat to walk away from the deal by May 12; and ongoing signs of progress regarding North Korea. It’s also likely that President Trump will extend the EU’s exemption from aluminium and steel tariffs beyond May 1 when it currently expires, but it may involve the use of quotas.

So it’s back to focussing on economic fundamentals, notably the risk of a more aggressive Fed. A few weeks ago the big concern was the flattening US yield curve partly as investors fretted that a trade war would slow global growth with PMIs softening a bit. As always, we need to be cautious of the crowd as its now swung back to focussing on strong growth and the risk of higher inflation in the US, with the US 10-year bond yield briefly closing above 3% for the first time since 2013 on the back of strong data, rising inflation and rising fears around the Fed.

Our view remains that the market has been too complacent on the Fed (factoring in just two more hikes this year and one next) and we continue to see three more hikes this year and another three next year. This will cause ongoing volatility. However, bond yields are only rising because of stronger growth, while US profit growth may be close to peaking (at over 20% year on year in the March quarter) it’s likely to continue growing solidly, US monetary policy is a long way from being tight and Europe and Japan are a long way from any monetary tightening. And with now very high short positions in US bonds, yields aren’t going to go up in a straight line.

Also, don’t forget that a 3% US bond yield implies a real yield of just 1% which is very low historically. With the forward PE on US shares having fallen to 16.8x it means that the gap between the earnings yield of 5.95% and the 3% 10-year bond yield is still relatively wide at around 3%. In Australia, the earnings yield bond yield gap is higher at around 3.5%, and in Europe its much higher at around 6% and in Japan it’s around 7%. So bond yields can rise a fair bit further before they become a major threat for shares.

Source: Bloomberg, AMP Capital

In Australia, APRA has formalised a further tightening in lending standards, at the same time as removing the now redundant 10% investor lending speed limit. Removing the speed limit makes sense given that investor credit growth was just 2.8% over the year to February, the property market in Sydney and Melbourne has cooled and the speed limit is being replaced by a more fundamental tightening in lending standards including around interest only lending (last year) and now much tougher requirements around borrowers’ income and expenses and bank attitudes towards borrowers’ total debt to income. Given this and more realistic investor expectations regarding future capital growth it’s hard to see a resurgence in investor lending, particularly in relation to Sydney and Melbourne. To the contrary, I expect that the tighter lending policies and practices will mean a further net tightening in lending conditions leading to a further slowing in credit growth which in turn will maintain downwards pressure on home prices in Sydney and Melbourne, where I continue to expect prices to fall another 5% or so this year, another 5% or so next year and prices to still be falling slightly in 2020.

No RBA rate hike until sometime in 2020. We had been expecting the RBA to start raising rates in early 2019 but with the further tightening in bank lending standards effectively doing the RBA’s work for it and growth likely to remain below 3% and inflation around 2% for longer we now don’t see an RBA tightening until sometime in 2020. With the Fed likely to continue hiking this only adds to confidence in our view that the $A will fall towards $US0.70. And on this front its noteworthy that it appears to be breaking below the rising trend line that’s been in place since 2015.

The 2018 Federal Budget to be handed down on Tuesday 8th May is likely to look like a pre-election budget aimed at improving the Government’s standing ahead of the next Federal election. A big improvement in in the underlying budget position on the back of increased corporate tax revenue, strong employment growth and lower spending is expected to see the deficit for this financial year fall to $17bn from the $29bn projected in last year’s Budget. This would allow the projected return to surplus to be brought forward a year to 2019-20 but the Government is likely to “spend” much of the revenue windfall and leave the return to surplus in place for 2020-21. The key elements of this pre-election budget stimulus are likely to be personal tax cuts for low and middle-income earners possibly starting as early as July this year but more likely sometime next year, the dropping of the 0.5% increase in the Medicare levy, more infrastructure projects and maybe some increase in health spending. Financial sector regulation may also get a boost in view of the Royal Commission. Key Budget numbers for 2018-19 are expected to be: a Budget deficit of $16bn, real GDP growth of 3%, inflation of 2.25%, wages growth of 2.5% and unemployment of 5.25%.

The upside of the Australian Government’s Budget strategy is that consumers will be given a shot in the arm at a time of soft wages growth, falling home prices in Sydney and Melbourne and tightening bank lending standards. And the fiscal stimulus will be nowhere near the 2% of GDP seen recently in the US.  The downside is that we will still be seeing a record 12 years of budget deficits with nothing put aside for the next rainy day and there is a risk that the revenue surprise seen lately will prove ephemeral if global growth is threatened and/or employment slows.

Major global economic events and implications

US data over the last week was mostly strong. Underlying durable goods were softer than expected but April business conditions PMIs, home sales, home prices and consumer confidence all rose, jobless claims fell and the goods trade deficit narrowed. The March quarter employment cost index rose 0.8% quarter on quarter and 2.7% year on year, its fastest pace since before the GFC, indicating wages growth is continuing to accelerate. While March quarter GDP growth was 2.3% annualised adjusting for weak seasonality in the March quarter indicates an above trend pace of around 3%.  The US earnings reporting season is now 53% done and is very strong. 78% of results to date have beaten on earnings and 69% have beaten on sales. Companies reporting to date have seen earnings growth of 27% year on year, so overall earnings growth is on track to come in above 20%, with the bulk of the strength coming from underlying conditions and about 7 percentage points coming from tax cuts.

As expected the ECB left monetary policy on hold, remaining on track towards a tapering in QE in the final quarter but with no rate hike likely until mid-2019 at the earliest. If anything, ECB President Draghi sounded a bit dovish.  There is no quick exit from easy money here. Business conditions PMIs and economic confidence stabilised in April, in contrast to German and French business confidence readings that slipped a bit further. The ECB’s latest bank survey showed easier lending conditions and rising loan demand though. Overall Europe looks good and the now falling again Euro will take a bit of pressure of, but it’s not enough to speed up the ECB.

The Bank of Japan also made no changes to monetary policy as expected and lowered its expectations around inflation. While March labour market and industrial production data were strong and the April manufacturing conditions PMI improved slightly, core national inflation at just 0.5% year on year (and now just 0.3% in Tokyo) indicates that there will be no quick exit from easy money in Japan.

China moving to stimulate? China’s latest Politburo meeting was interesting with talk of stimulating domestic demand with no reference to deleveraging. Its premature to expect a significant stimulus – growth is not weak enough (6.8% in the March quarter) and the Government is still aware of issues around debt – but it reinforces the view that a significant slowing will not be tolerated. Taken together with either stronger or stable PMIs in the US, Europe and Japan in April it adds to confidence global growth will remain strong.

Australian economic events and implications

Australian inflation remains in the slow lane consistent with the RBA remaining on hold. While the March quarter saw large rises in prices for health, education and utilities weak pricing power is continuing to keep inflation at or just below the bottom of the 2-3% inflation target. Signs of weak underlying inflation remain evident in falling prices for clothing, furnishing, household goods, communication and recreation with private sector inflation excluding volatile items running at just 1.1% year on year. There is no case for RBA tightening here.

What to watch over the next week?

In the US, the Fed (Wednesday) is expected leave interest rates on hold but indicate that it remains on track to continue raising interest rates gradually on the back of strong growth and rising inflation. Market expectations for just two more rate hikes this year remain too complacent and we continue to see three more this year with the next move in June. Data showing a rise in March core private consumption deflator inflation (Monday) to 1.9% year on year, continued strength in employment (Friday) with April payrolls likely to rise by 190,000 and wages growth edging up to 2.8% year on year are expected to provide support for continued Fed tightening. In other data expect solid gains in household income and spending (Monday), a rise in pending home sales (Tuesday) and continuing strength in the ISM manufacturing conditions index (Tuesday) and non-manufacturing conditions index (Thursday). Meanwhile, the March quarter earnings reporting season will continue.

In the Eurozone, March quarter GDP (Wednesday) is expected to have increased by 0.4% quarter on quarter seeing annual growth slip slightly to 2.6% year on year and March unemployment (also Wednesday) is expected to fall further to 8.4%. However, April core inflation (Thursday) is likely to have remained unchanged at 1% year on year.

Chinese business conditions PMIs (due Monday and Wednesday) are expected to edge down a bit but remain around 51 for manufacturing consistent with growth running around 6.5-6.8% year on year.  

In Australia, the Reserve Bank is expected to leave interest rates on hold for a record 20th month in a row when it meets on Tuesday. Strong business confidence, improving non-mining investment, solid global growth and the RBA's own growth and inflation forecasts argue against a rate cut, but risks around consumer spending, tightening bank lending standards, weak wages growth and inflation, the slowing Sydney and Melbourne property markets and the still too high $A argue against a rate hike. We now don’t see the RBA commencing a tightening cycle until sometime in 2020 and another rate cut cannot be ruled out. The RBA is expected to make only minor changes to its 2018 forecasts in its Statement of Monetary Policy (Friday) with a slight rise in its underlying inflation forecast to 2% and a downgrade in its growth forecast to 3%, but these are unlikely to affect the outlook for interest rates.

Meanwhile on the data front in Australia, expect: credit growth (Monday) to remain moderate; CoreLogic data for March to show continuing weakness in home prices (Tuesday) led by Sydney; a 2% or so bounce in building approvals for March (Thursday); and a March trade surplus of around $1bn (also Thursday). Business conditions PMIs for April are likely to remain solid.

Outlook for markets

Volatility in share markets is likely to remain high as US inflation and interest rates move up and as issues around President Trump, trade, Mueller inquiry, etc, continue to impact ahead of the US mid-term elections in November, but the medium-term trend in share markets is likely to remain up as global recession is unlikely and earnings growth remains strong globally and solid in Australia. We continue to expect the ASX 200 to reach 6300 by end 2018 – it might take a bit longer to get back on the path up to there though.

Low yields and capital losses from rising bond yields are likely to drive low returns from bonds. Australian bonds are likely to outperform global bonds helped by the relatively dovish RBA in contrast to the Fed.

Unlisted commercial property and infrastructure are still likely to benefit from the search for yield by investors, but it is waning, and listed variants remain vulnerable to rising bond yields.

National capital city residential property price gains are expected to slow further as the air continues to come out of the Sydney and Melbourne property boom and prices fall by another 5% this year, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.

The $A is likely to fall towards $US0.70 as the gap between the RBA’s cash rate and the US Fed Funds rate pushes further into negative territory. Solid commodity prices should provide a floor for the $A though – in contrast to early last decade when the interest rate gap was negative and the $A fell below $US0.50.

 

Economic update: Syria strike fears and US inflation

Monday, April 16, 2018

Share markets rose over the last week. While volatility remained high, not helped by worries about a missile strike on Syria and the FBI raiding Trump's lawyer's office, trade war risks receeded. US shares rose 2%, Eurozone shares rose 1.2%, Japanese shares gained 1%, Chinese shares rose 0.4% and Australian shares rose 0.7%. The risk on mood saw bond yields, commodity prices and the Australian dollar rise.

Good news on the trade front as China continues down the path of opening its economy despite US tariff threats, and Trump responds favourably. But there is still a long way to go. President Xi’s Boao forum address was extremely positive in reiterating that China will lower tariffs on certain products, ease access for foreign investors and strengthen protections for intellectual property. Yes China is playing good cop (President Xi and Premier Li)/bad cop (with various underlings like Commerce Ministry spokesman Goa Feng talking of Chinese retaliation if the US further escalates trade tensions) in this so far “phoney trade war”. It has to do this if its to achieve a fair outcome for China. But overall China is taking the high ground here in acknowledging its surplus with the US is unsustainable, continuing down a path of opening its economy and implicitly acknowledging the need to protect intellectual property. And President Xi’s comment that cold war, zero sum mentalities are “out of place” and that dialogue is the way to resolve disputes clearly indicates its open to negotiation with the US on trade. This issue has a long way to go yet and there may still be lots of sniping in public. But so far Trump has praised President Xi’s speech and said the tariffs may not be levied. However, the ball is now in his court to get the negotiations going formally.

Of course, the worry list for investors remains long with the possibility of another military strike on Syria looming large and the Mueller inquiry getting even closer to Trump. In terms of Syria, yes the risk is significant – but stuff in the middle east has been flaring up and down for years without much lasting impact on global financial markets. The Mueller inquiry is more of a slow burn reminiscent of Watergate, but the story hasn’t changed. Unless Trump is shown to have done something really bad he won’t be impeached/removed from office and if he is it will be rough for markets along the way, but US economic policy won’t change much under VP Pence. Some might say it would be more peaceful – with no twitter grenades from the President!

The last few weeks have seen lots of market gyrations driven by President Trump’s comments. A week ago he said he was considering tariffs on another $US100bn of imports from China, now he says that the tariffs may not be levied and he considering re-joining the TPP. A few days ago he declared that missiles “will be coming” to Syria and then a few days later they are still being considered. All these gyrations are just classic bargaining/Art of the Deal stuff that creates lots of volatility for traders. But for most investors it’s a case of turn down the noise and stick to a well thought out long term investment strategy.

While the volatility could go on for a while some things are worth noting regarding the direction setting US share market: the lows reached in February have held after the retest of the last few weeks; the forward PE has fallen to a reasonable 16 times, corporates are accelerating buybacks and M&A and investor sentiment has become very negative and profit growth is very strong, all suggesting scope for a bounce back if the news flow becomes a bit less negative. This would flow through to global shares including the Australian share market.

In Australia, tightening lending standards around tougher checks of borrower income and expense levels are upon us. At least one of the major banks have announced formal changes in their standards on this front and for the last week I have heard multiple anecdotes of the extra hoops borrowers now have to jump through to get a loan. The economic impact is likely to be a slowing in housing related credit growth and since the tightening will more likely hit marginal borrowers in Sydney and Melbourne given higher home price to income ratios it reinforces the downside to home prices in these cities and the uncertainty around consumer spending. It’s also a de facto monetary tightening and with the pressure from rising short term funding costs on mortgage rates will likely mean a lower outlook for the RBA’s cash rate. We are looking for a rate hike around February next year, but the risk is that this will be delayed into 2020 and another cut in rates cannot be ruled out.

Major global economic events and implications

US inflation pressures continuing to rise, with the Fed on track for more hikes than the market is allowing for. Core producer price inflation rose 2.7% year on year in the March quarter and core consumer price inflation rose to 2.1% (from 1.8%) as the “Verizon unlimited data plan effect” from a year ago is dropping out. Over the last six months core inflation has been running at a 2.6% annual pace. The Fed’s preferred core consumption deflator is running below the core CPI inflation rate, but it will be heading up too as last year’s mini bout of deflation drops out and capacity utilisation continues to tighten in the US. With the US jobs market remaining ultra-tight and small business optimism remaining very strong we remain of the view that the Fed will hike four times this year. Market expectations for three hikes this year remain too dovish.

Eurozone industrial production fell again in February for the third month in a row, but still strong business conditions PMIs indicate it will bounce back. Meanwhile the minutes from the last ECB meeting came across as somewhat dovish with concerns about the strength of the Euro. There are no signs of an early exit from easy money or a rate hike here.

But not everyone is seeing inflation rise - Chinese inflation fell in March providing no impetus for any PBOC tightening. Chinese exports also fell in March, but this mainly reflects distortions caused by the timing of the Lunar New Year with growth being very strong in the March quarter as a whole and the same for imports. Credit and money supply growth in March was weaker than expected,

Australian economic events and implications

Australian data was rather bland over the last week. The NAB business survey showed business conditions and confidence slipping in March but that was down from unbelievably strong levels and they remain solid. Consumer confidence fell slightly and remains below business confidence, which is likely to remain the case until wages growth picks up. Meanwhile, housing finance going to first home buyers has continued to improve but is at risk from the current tightening in lending standards around income and expenses as they tend to have to stretch more to get a mortgage.

The RBA’s Financial Stability Review sees the risks around household debt in Australia as having fallen thanks to macro-prudential measures. More broadly, it sees the resilience of Australian banks as improving and is not too fussed by the rise in short term funding costs.

The Rider, Levett, Bucknall count of cranes being used for residential construction has started to fall, mainly driven by Sydney. However, approvals remain high so the crane count is likely to remain high for a while yet. Meanwhile, the reduction in residential cranes has been offset by a rise in cranes being used for office, hotel, retail & education construction.

Source: Rider, Levett, Bucknall Crane Index, AMP Capital

What to watch over the next week?

In the US, expect a solid 0.3% gain in March retail sales (Monday) after several soft months, the NAHB home builders’ index (also Monday) to remain strong with housing starts (Tuesday) up solidly and a 0.3% gain in industrial production (also Tuesday). Manufacturing conditions surveys for the New York and Philadelphia regions will also be released along with the Fed’s Beige Book of anecdotal evidence. The March quarter earnings reporting season will start to ramp up. Consensus expectations are for a 17% year on year rise in earnings, but this could be too conservative given that tax reform provided a 5-10 percentage point boost which could take profit growth above 20%.

Japanese inflation data (Friday) is likely to show a fall in CPI inflation to 1.1% year on year from 1.5% and core inflation remaining at 0.5% year on year.

Chinese March quarter GDP growth is likely to have remained at 6.8% year on year consistent with reasonably solid business conditions PMI readings so far this year and PBOC Governor Yi Gang indicating growth has been a bit better than expected. Consistent with this March retail sales growth is expected to rise slightly to 9.7% yoy with industrial production rising to 6.5% yoy, but fixed investment growth slowing to 7.7%.

In Australia, March employment growth (Thursday) is likely to be around 10,000 jobs with leading jobs indicators remaining solid but unemployment will likely remain around 5.6%.

Outlook for markets

Volatility in share markets is likely to remain high as US inflation and interest rates move up and as issues around President Trump and trade continue to impact ahead of the US mid-term elections in November, but the medium-term trend in share markets is likely to remain up as global recession is unlikely and earnings growth remains strong globally and solid in Australia. We continue to expect the ASX 200 to reach 6300 by end 2018 – it might take a bit longer to get back on the path up to there though.

Low yields and capital losses from rising bond yields are likely to drive low returns from bonds.

Unlisted commercial property and infrastructure are still likely to benefit from the search for yield by investors, but it is waning, and listed variants remain vulnerable to rising bond yields.

National capital city residential property price gains are expected to slow to further as the air continues to come out of the Sydney and Melbourne property boom and prices fall by another 5% this year, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.

The $A is likely to fall towards $US0.70 as the gap between the RBA’s cash rate and the US Fed Funds rate pushes further into negative territory. Solid commodity prices should provide a floor for the $A though – in contrast to early last decade when the interest rate gap was negative and the $A fell below $US0.50.

 

Week in review: Another volatile week for the market

Monday, April 09, 2018

Share markets had another volatile week - starting down as the US announced details of proposed 25% tariff hikes on $US50bn of imports from China and as China announced its own plans for same sized tariffs. There was a rebound as investors came to the view that some sort of negotiated solution was most likely only to come under renewed pressure again when Trump threatened tariffs on an extra $US100bn of Chinese exports to the US. This saw US shares fall 1.4% through the week, but other markets still managed a modest rise with Eurozone shares up 1.1% and Japanese and Australian shares up 0.5%. Chinese shares fell 1.1%. Bond yields had a calmer roller coaster ride but mostly rose, commodity prices were mixed with oil and iron ore down but metals up. The $A fell on trade war fears and as the $US rose.

While the details around the proposed product list totalling $US50bn of imports from China to be subject to a 25% tariff hike and China’s announcement of a planned same size retaliation were not surprising, Trump’s ordering the US Trade Representative to “consider” tariffs on an additional $US100bn of imports to the US in counter retaliation ratchets up the risk of a serious trade war between the two countries if negotiations fail. While tariffs on $US50bn of imports would have very little impact (amounting to around a 0.4% tariff increase averaged across all US imports which would impact growth and inflation by less than 0.1%) a ratcheting up in the products subject to tariffs will mean a greater economic impact. The additional $US100bn response if it is adopted by the US Trade Representative will likely also be followed at some point by China announcing another matching tariff hike on imports from the US running the risk that Trump ups the ante yet again.

However, all of these tariff hikes are still just proposals and the latest $US100bn will have to go through the same 60 day public comment period as the initial $US50bn is going though. The US tariffs and matching Chinese tariffs will only go into effect if negotiations fail. Both China and the US have indicated their support for negotiations. While America stands to lose less from a trade war than China (because it is less trade exposed and it has a trade surplus) it will still lose. China’s proposed tariffs on US soybeans, aircraft, whiskey, wheat etc will hit Trump’s supporter base.  And he would prefer to see the share market going up, not down, particularly the closer we get to the mid-term elections.

So, while Trump is upping the stakes and the threat to the global economy if negotiations with China fail, our view remains that a negotiated solution is most likely, and so the tariffs ultimately won’t be implemented or will be much milder if they are. However, negotiations could take months. In the meantime, there will be ongoing noise around the issue – with China and the US potentially announcing a further escalation in their proposed tariffs, the US Trade Representative to hold public hearings on the initially proposed tariffs in mid-May and the US Treasury likely to announce its recommended investment restrictions on China in late May, which will lead to more tensions.

So, it will likely remain a case of no full-blown trade war, but no trade peace either. Against this backdrop, share market volatility will likely remain high But global growth should remain solid and so the rising trend in shares will likely resume once the trade worries start to settle down (which is likely to be the case ahead of the US mid term elections later this year).

What would be the impact of a full-blown trade war? This is always a bit hard to model reliably - Chinese and US goods flowing to each other could just be swapped for goods coming from countries not subject to tariffs reducing any impact. But modelling by Citigoup of a 10% tariff hike by the US, China and Europe (and bear in mind we are nowhere near that at present) showed a 2% hit to global GDP after one year with Australia seeing a 0.5% hit to GDP reflecting its lower trade exposure compared to many other countries.

The US dollar looking interesting. Earlier this year talk that the Bank of Japan and the ECB may be getting closer to an exit from easy money put more downwards pressure on the US dollar. The problem is that the rise in the Euro and Yen against the $US has adversely affected growth indicators like PMIs in Japan and Europe relative to the US and the BoJ and ECB are just following their earlier announced plans regarding easy money with no sign of an early exit. So the $US fell too far into February and looks like it’s built a base for a rally. This in turn is also likely to weigh on the $A as US rates rise further relative to Australian rates.

Major global economic events and implications

US data remains solid. The March business conditions ISM indexes edged down a bit but remain very strong with continuing strong readings for orders, employment and prices paid. While payrolls rose a less than expected 103,000 in March, this looks to reflect payback for the stronger than expected gain of 326,000 in February, normal monthly noise and the impact of bad weather. Meanwhile, unemployment remains low, underemployment fell and wages growth edged up a bit further to 2.7% year on year which are all consistent with the jobs market remaining strong. The Atlanta Fed’s GDPNow has March quarter GDP growth tracking around 2.3% but note that this is around 3% if seasonal weakness in March is allowed for. All of which is consistent with the Fed continuing along its path of gradual rate hikes as implied by a speech by Fed Chair Powell.

Eurozone unemployment fell further to 8.5% in February – which is well down from its 2012 peak of 12%. But while the economy is continuing to improve core inflation remains stuck at 1% year on year which will keep the ECB cautious in moving towards the exit from ultra-easy monetary policy. While German industrial production fell sharply in February this appears to reflect a high number of workers on flu related sick leave.

Japanese data was mixed. Unemployment rose slightly to 2.5% in February and household spending slowed, but industrial production rose solidly, wages growth looks to be rising and the March quarter Tankan remained solid.

Chinese business conditions PMIs for March were mixed - up for the official surveys but down according to the Caixin surveys. Put an average through them and they are tracking sideways at a level consistent with continued solid growth.

Australian economic events and implications

In Australia, the RBA provided no surprises leaving rates on hold for a record 20 months in a row. The global economy is strong, the RBA does not appear too fussed about recent share market volatility, the risk of a trade war and higher bank funding costs, business conditions and employment growth are strong and the RBA continues to expect a pick-up in growth and inflation. But against this there is uncertainty around the outlook for consumer spending, labour market spare capacity remains high, wages growth remains low (although it may have troughed), inflation remains low and measures by APRA to tighten lending standards have helped cool the Sydney and Melbourne property markets. So, it makes sense to remain on hold.

Australian economic data was mixed with strong business conditions PMI readings and a stronger than expected rise in February retail sales, but a fall back in building approvals and another decline in home prices led by Sydney and Melbourne. The trade surplus slipped in February but only a bit and looks like it could make a contribution to growth in the March quarter.

What to watch over the next week?

No doubt the drama over tit for tat tariff hike plans in the US and China will continue to feature heavily over the week ahead. Key to watch will be progress towards negotiations.

In the US, the minutes from the Fed’s last meeting (Wednesday) will no doubt be watched to see what it says about the risk of trade wars but it’s like to remain consistent with further gradual monetary tightening. March quarter inflation data is likely to provide support for this with a further rise in core producer price inflation (Tuesday) and core CPI inflation (Wednesday) showing a lift to 2% year on year from 1.8%. The March quarter earnings reporting season will also kick off. Consensus expectations are for a 17% year on year rise in earnings, but this could be too conservative given that earnings were up 15% yoy in the December quarter and tax reform could provide a 5-10 percentage point boost which would potentially take profit growth above 20%.

Chinese data for March will start to flow with producer price inflation expected to slow to 3.2% yoy and consumer price inflation likely to slow to 2.5% yoy (both due Wednesday). Trade data is likely to show a slowing in export growth to 12% yoy after Lunar new year holiday distortions in the previous two months and import growth is likely to rise to 10% yoy. Credit data will also be released.

In Australia expect, the NAB business survey (Tuesday) to show continuing strength in business conditions and confidence, consumer confidence (Wednesday) to remain a bit above its long-term average and housing finance (Thursday) to show a 1% rise. A speech by RBA Governor Lowe (Wednesday) will be watched for any clues on the outlook for interest rates but is likely to remain consistent with rates staying on hold and the RBA’s Financial Stability Review (Friday) will likely show the RBA feeling more relaxed around housing related risks.

Outlook for markets

Volatility in share markets is likely to remain high and further weakness is possible as US inflation and interest rates move up and as issues around President Trump and trade continue to impact ahead of the US mid-term elections in November, but the medium-term trend in share markets is likely to remain up as global recession is unlikely and earnings growth remains strong globally and solid in Australia. We continue to expect the ASX 200 to reach 6300 by end 2018 – it might just take a bit longer to get back on the path up to there.

Low yields and capital losses from rising bond yields are likely to drive low returns from bonds.

Unlisted commercial property and infrastructure are still likely to benefit from the search for yield by investors, but it is waning, and listed variants remain vulnerable to rising bond yields.

National capital city residential property price gains are expected to slow to around zero as the air continues to come out of the Sydney and Melbourne property boom and prices fall by around 5%, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.

The $A is likely to fall further as the gap between the RBA’s cash rate and the US Fed Funds rate pushes further into negative territory. Solid commodity prices should provide a floor for the $A though – in contrast to early last decade when the interest rate gap was negative and the $A fell below $US0.50.

 

The week in review: Are the trade war risks exaggerated?

Monday, March 26, 2018

Investment markets and key developments over the past week

  • Share markets fell sharply over the last week not helped initially by tech stocks due to a privacy breach at Facebook and then later in the week after President Trump proposed tariffs on $US50bn of imports from China fuelling renewed fears of a trade war. Further changes in Trump’s team with John Bolton replacing HR McMaster as National Security Adviser were also seen as adding to the risk of a more hawkish/less market friendly US foreign policy including towards Iran. And more mayhem around avoiding another government shutdown in the US didn’t help either. Over the week US shares lost 5.9%, Eurozone shares fell 3.4%, Japanese shares fell 4.9% (not helped by a rising Yen), Chinese shares lost 3.7% and Australian shares fell 2.2%. This has taken US shares (down 10% from their January high), Chinese shares (down 11% from their January high) and Australian shares (down 5% from their January high) back to around their February lows and Eurozone shares (down 9% from their January high) and Japanese shares (down 15% from their January high) have gone below them. Reflecting safe haven demand, bond yields fell. Commodity prices were mixed though with oil and gold up but copper and iron ore down. The $A fell but only slightly.
  • Trump proposes tariffs on around $50bn of imports from China along with proposed restrictions on Chinese investment in the US and China threatens to hit back with a tariff on $US3bn on imports from the US. It looks scary and the risk of a trade war has escalated, but it’s not necessarily on the way. Trumps latest move was well flagged (although share markets didn’t seem to think so!) and flows from a US investigation into the alleged theft of US intellectual property by China. However, while it looks messy there are grounds for optimism that an all-out trade war between the two countries will be avoided. 
  • First, the $US50bn or so from 25% tariffs that Trump is talking about may not be that significant. It’s a bit unclear what it refers to – 25% tariffs that raise $US50bn of tariff revenue or a 25% tariff on $US50bn of imports from China? If it’s the latter its only $US12.5bn in extra tariff revenue and would amount to an average tariff increase across all Chinese imports to the US (which total $US500bn) of just 2.5% which would actually have a very minor macro-economic impact – eg, less than a 0.05% boost to US inflation. 
  • Second, so far the US tariffs on China are really just a proposal – they have not yet been implemented. The goods affected have yet to be worked out and after that there will a period of public comment, so it could take up to 45 days before they are implemented. So, there is plenty of scope for US industry to challenge them and for a deal with China. In fact, Trump’s aim looks to be a negotiation with China so consistent with The Art of the Deal he is going in hard up front with the aim of extracting something more acceptable to both. The press release from President Trump actually says “...After a period of notice and comment…and consultation…the US Trade Representative shall…publish a final list of products and tariff increases, if any, and implement any such tariffs”. The reference to if any clearly leaves the door wide open to a negotiated solution with China. Just as we saw with his steel and aluminium tariffs, the initial announcement that seemed to apply to all countries has since been softened to exempt several countries including Canada, Mexico, the EU, Australia, Brazil and Korea.
  • Fourth, despite China’s planned retaliation (which with tariffs on $US3bn of imports from the US is tiny!), it looks open to negotiation with Chinese Premier Li a few days ago acknowledging that China’s trade surplus is unsustainable, talking of tariff cuts and pledging to respect US intellectual property. While the Chinese Ambassador to the US has said “We are looking at all options”, raising fears China will reduce its purchases of US bonds, Premier Li actually played this down earlier in the week and doing so would only push the $US down/Renminbi up which would add to the tariffs in making Chinese exports less competitive. Its arguably in China’s interest to remain calm, do little on the retaliation front and try to come off as the good guy. 
  • Finally, despite what he says in his tweets, a full-blown trade war is not in Trump’s best interest either as it will mean higher prices in Walmart and hits to US exports like Harleys, Jack Daniels, cotton, pork and fruit that will not go down well with his base and he likes to see a higher, not lower, share market. As a result, a negotiated solution with China looks to be the more likely outcome. That said trade is likely to be an ongoing issue causing share market volatility in the run up to the US mid-term elections with Trump again referring to more tariffs. So while we may not see a full on trade war, we won’t see trade peace either.
  • Out of interest $US50bn would be 10% of Chinese exports to the US and 2% of its global exports. Australia is vulnerable to a US/China trade war as 33% of our exports go to China (mostly raw materials) with some turned into goods that go to US. The impact on Australia may be less than feared if the US tariffs, as flagged, focus on aerospace, IT and machinery. That said it’s in Australia’s interest to do the best it can to work with both our partners to help head off any trade war.
  • Fed more upbeat and we continue to expect four rate hikes this year. Another 0.25% rate hike was no surprise and supporting this the Fed noted that the economic outlook has strengthen and revised up its growth and inflation forecasts and its expected interest rate increases over the next three years. While the median Fed official still sees three hikes this year it will only take one more official to move up to see the median move to four which is likely to happen in June. US monetary policy is a long way from being tight and so is a long way from threatening US growth, but its still likely to be a source of market volatility this year and a constraint on share market returns. For Australia, the RBA is a long way from following the Fed thanks to there being much more spare capacity in the Australian labour market and hence much weaker wages growth and so we don’t see the RBA starting to raise rates until early next year. So while rising US interest rates risk some upwards pressure on Australian bank funding costs and hence maybe on fixed mortgage rates, for owner occupier variable rates this is likely to be offset by continuing low official interest rates in Australia. For the $A, the now negative interest rate gap versus the US which is likely to blow out to near 1% by year end, points to downwards pressure on the $A. 

Major global economic events and implications

  • US business conditions PMIs fell this month but remained in the solid range they have been in for the last 18 months and the leading index, durable goods orders and existing home sales were strong. While Friday saw a bit of drama around the risk of another Government shutdown, with Trump initially refusing to sign a bill providing funding for six months (on the grounds that there was no solution for the wall or Dreamers – so much for the “bill of love”!) he ultimately signed it. So at least there is no shutdown.
  • Eurozone business conditions PMIs slipped in March, possibly suggestive of a dampening impact from trade war fears and from the stronger Euro. That said they remain strong and consumer sentiment remained unchanged at a high level.
  • Japan’s manufacturing conditions PMI also slipped in March but remain relatively high. Meanwhile core inflation edged up to 0.5% year on year in February (from 0.4%) as expected, but it’s still a long way from the 2% target so the Bank of Japan’s easy money program still has a long way to go.
  • China raises interest rates, but not enough to get excited about. The PBOC increased its key 7-day money market rate by 5bp to 2.55%. It’s likely part of the deleveraging effort and also to contain capital outflows after the latest Fed hike, but its hard to get excited as it was only 5bps! Meanwhile, China’s moves to reorganise and streamline government departments and regulators, a new leadership team of four vice-premiers and the appointment of former PBOC deputy governor Yi Gang as governor are all consistent with pursuing President Xi Jinping’s reform agenda. Yi Gang’s appointment in particular signals continuing support for retiring PBOC Governor Zhou’s policies to open the economy and modernise monetary policy.   

Australian economic events and implications

  • In Australia, jobs growth remained strong in February but it’s just keeping up with labour force growth. The good news is that employment is up a very strong 3.5% over the last year, full time jobs are up by 4% and leading labour market indicators like job vacancies and hiring plans point to continued strength. Against this, unemployment is trending sideways as rising participation and strong population growth boost the labour force and worker underutilisation remains very high at just below 14%. All of which points to wages growth remaining low and the RBA staying on hold. 
  • Which is what the minutes from the RBA’s last meeting implied it is likely to do. However, there were two things of interest in the minutes. First, the RBA appears to have paved the way for a downgrade to its growth forecasts for this year indicating that it expects growth to be above potential which at around 2.75% or so is a lower hurdle than its previous description of above 3%. Second, the RBA is not too fussed by the reset of interest only to principle and interest loans noting that the schedule of resets will be little different from recent years and while it would be significant for individual households the aggregate impact on consumer spending is likely to be small.
  • Meanwhile, Australian population growth remains strong at 1.6% year on year in the September quarter last year. This was led by Victoria at +2.4%yoy helping explain the resilience of the Melbourne property market, the ACT at 1.8%yoy, Queensland at 1.7%yoy (likely to be next to see faster property prices?), NSW at 1.6%yoy, WA at +0.9%yoy, Tasmania at 0.7%yoy and NT flat. Clearly this is a boost to overall economic growth (albeit its per capita growth that counts and we aren’t doing so well on that front) and to underlying housing demand which combined with a failure to boost housing supply until recently to match underlying demand explains why housing is so poorly affordable in many Australian cities.
  • What’s the risk of a Banking Royal Commission induced credit crunch? We are only two weeks into the Royal Commission, but it seems a real risk around the issues of lax lending standards is that banks move to a far more rigorous assessment of applications for loans – in terms of each applicant’s income, expenses, assets and other debts. This is most unlikely to cause a full-on credit crunch, but the end result could be much tougher lending standards and a slowing in credit growth. Its early days yet but it’s worth keeping an eye on. It could serve to further delay any move to higher interest rates by the RBA, into say 2020.

What to watch over the next week?

  • In the US, the focus will be back to inflation with the Fed’s preferred inflation measure, the core private consumption deflator, for February to be released on Thursday likely to show a small rise in annual inflation to 1.6% year on year, but with some pick up in short term momentum. While personal spending is likely to have been soft, disposable income growth is likely to be strong pointing to a pick-up in spending ahead. Meanwhile expect consumer confidence to be strong, home price growth to remain solid (both due Tuesday) and pending home sales (Wednesday) to show a bounce back. 
  • Eurozone economic confidence readings (Tuesday) for March are likely to have slipped, but remain strong.
  • Japanese data for February (Friday) is likely to show a bounce in industrial production and continuing labour market strength.
  • Chinese business conditions PMIs will be released Saturday.
  • In Australia, it’s going to be a relatively quiet week with ABS job vacancy data for February likely to show continued strength and credit growth (both due Thursday) likely to remain moderate.

Outlook for markets

  • Volatility in share markets is likely to remain high and further weakness is possible as US inflation and interest rates move up and as issues around President Trump and trade continue to impact, but the medium-term trend in share markets is likely to remain up as global recession is unlikely and earnings growth remains strong globally and solid in Australia. We continue to expect the ASX 200 to reach 6300 by end 2018 – it might just take a bit longer to get back on the path up to there. 
  • Low yields and capital losses from rising bond yields are likely to drive low returns from bonds.
  • Unlisted commercial property and infrastructure are still likely to benefit from the search for yield by investors, but it is waning, and listed variants remain vulnerable to rising bond yields. 
  • National capital city residential property price gains are expected to slow to around zero as the air continues to come out of the Sydney and Melbourne property boom and prices fall by around 5%, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms. 
  • Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.
  • The $A is likely to fall as the gap between the RBA’s cash rate and the US Fed Funds rate pushes further into negative territory. Trade war fears could also drive it lower. Solid commodity prices should provide a floor for the $A though – in contrast to early last decade when the interest rate gap was negative and the $A fell below $US0.50.
  • Eurozone shares fell 1.2% on Friday and the US S&P 500 fell 2.1% as worries about a trade war, China slowing US bond buying, whether John Bolton’s appointment to Trump’s team will increases the risk of sanctions on Iran and worries about another US Government shutdown all weighed. As a result of the weak global lead ASX 200 futures fell 51 points or 0.9% pointing to a weak start to trade for the Australian share market on Monday. 

 

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