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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.

Property & shares: where are markets heading?

Monday, October 15, 2018

Share markets fell sharply last week, led by the US share market, primarily on the back of worries about rising interest rates and bond yields and the deteriorating US/China relationship. More volatility is likely, even though it’s unlikely to be the start of a major bear market. Every so often, shares go through rough patches. We saw this most recently in February on the back of US inflation and interest rate concerns, which saw US shares fall 10% and Australian shares down 6%. Shares managed to get through the seasonably weak months of August and September surprisingly well (except in Australia) but the worry list has pulled them back down again. So far, shares are down around 7% from recent highs.

Given the ongoing worries around the Fed, inflation and bond yields, threats to tech stocks, the intensifying US/China conflict, rising oil prices, problems in the emerging world, the upcoming US mid-term elections, risks around President Trump and the Mueller inquiry and tensions in the Eurozone regarding the Italian budget, further weakness is likely. And given the usual global contagion, most major share markets, including the Australian share market, will be affected. However, we doubt it’s the start of a major bear market because history tells us that they invariably require a US recession. With US monetary conditions still far from tight, fiscal stimulus still impacting and no signs of the excess (in terms of overinvestment, debt growth, etc.) that normally precedes a recession, a US recession still looks a long way off and this in turn suggests that the trend in earnings and hence share markets is likely to remain up beyond the near term pull back.

We continue to see the trend in shares remaining up as global growth remains solid, helping drive good earnings growth and monetary policy remains easy. However, the risk of a further short-term correction is high, given the threats around trade, emerging market contagion, ongoing Fed rate hikes and rising bond yields, the Mueller inquiry, the US mid-term elections and Italian budget negotiations. Property price weakness and approaching election uncertainty add to the risks around Australian shares.

How confident are we?

Australian business and consumer confidence rose slightly in September and October respectively but both are well down on recent highs. 

How’s the property market heading?

Meanwhile, although housing starts fell in the June quarter consistent with falling building approvals and consistent with a peaking in housing construction activity, work yet to be done is at a record high, three times above where it was in 2009, telling us that there is still a lot of supply about to hit the softening homebuyer market. 

What about housing finance?

Housing finance also continued to slide, with commitments to both owner/occupiers and investors falling. All of which is consistent with ongoing falls in home prices.

What’s the outlook for residential property? 

National capital city residential property prices are expected to slow further with Sydney and Melbourne property prices likely to fall another 10% or so, but Perth and Darwin property prices at or close to bottoming, and Hobart, Adelaide, Canberra and Brisbane seeing moderate gains.

Source: ABS, AMP Capital

What’s the Reserve Bank’s position?

The RBA’s latest Financial Stability review remained positive on global conditions – but does see risks around trade and low risk premia - and remains relatively sanguine about the risks around the slowing Australian housing market and household debt. However, it does acknowledge that some existing borrowers may have difficulty refinancing and that it’s possible (but not probable) that tightening lending standards will worsen the housing slowdown. It is worth noting that despite all the talk about mortgage stress and foreclosures the major banks non-performing loans remain very low, although they have been rising mainly in WA.

What to watch this week…

In Australia, expect September labour market data, due Thursday, to show employment growth slowing to a gain of 10,000 after a surprise 44,000 gain in August but with unemployment remaining flat at 5.3%. Meanwhile, the minutes from the last RBA board meeting (tomorrow) are likely to show the RBA still expecting the next move in rates to be up but seeing no case to move now and the by-election for the seat of Wentworth will be watched closely in regard to the Government’s narrow parliamentary majority.

 

Can’t help falling

Monday, October 08, 2018

Share markets fell over the last week, largely in response to a renewed move higher in global bond yields. US shares fell 1%, Eurozone shares lost 1.8%, Japanese shares fell 1.4% and Australian shares fell 0.4%. Oil, gold and iron ore prices rose but copper prices fell. Strong US economic data and rising expectations for Fed tightening saw the $US rise and this saw the $A fall below $US0.71.

Still more upside

Global bond yields have resumed their rising trend, with more upside ahead. The break higher was led by the US 10-year bond yield, reaching a seven year high on the back of strong US economic data, rising oil prices and, most importantly, investors starting to come around to the view that the Fed Funds rate has a lot more upside and will likely ultimately rise above the Fed’s guesstimate of the “neutral” Fed Funds rate, which is around 3%. Of course, the Fed has been telling us this for a long time, but the market didn’t really believe it. However, the past week saw several Fed speakers, including Fed Chair Powell and normally dovish Chicago Fed President Evans reinforce that the Fed Funds rate is at least going to neutral and probably beyond. On this front, there is a long way for the market to adjust, given the gap between the Fed’s dot plot, which shows the Fed Funds rate going up to nearly 3.4% and market expectations, which remain well below that. This adjustment, along with investors moving to factor in more normal inflation and growth expectations, rather than the subdued expectations for both of recent years, suggests US and global bond yields still have more upside. At some point, this will seriously threaten shares, but that point is likely a fair way off, given that US monetary policy is still far from tight, central banks in Europe and Japan are way behind the US in tightening, bond yields are still relatively low, US and global growth is still strong and this is supporting earnings. And as we have seen since the 2016 low in bond yields, the rise in yields won’t go in a straight line.

Possible interest rate cut

Australian bond yields may go up a bit as US yields rise but they are likely to continue to lag given that the lagging Australian economy means that the RBA will remain on hold with some chance of a rate cut. However, the rise in US and global bond yields adds to the risk of more out of cycle bank mortgage rate increases as global funding costs rise (with banks getting around 35% of their funding from sources other than deposits). Of course, if out of cycle mortgage rate hikes become a problem for the Australian economy, it will provide a reason for the RBA to cut the cash rate to pull mortgage rates back down.

Trade tension with China spills into other areas

The new north American trade deal to be called USMCA (or US Mexico Canada Agreement) is good news but does not mean the US/China dispute will soon be resolved. The USMCA deal, coming on the back of the revamped US/South Korea trade deal and trade talks with the EU and now Japan, confirms that Trump is not anti-trade per se, but just wants what he thinks is fairer trade for the US. But its also consistent with him wanting to make trade peace with his allies and focus more on China. And on the US/China trade front the differences remain significant and both sides are likely to remain dug in until after the mid-term elections at least. Which means that the tariff rate on the latest $US200bn tranche of imports will likely rise to 25% next year and another tranche of tariffs remains possible. The near collision between Chinese and US naval ships in the South China Sea and a speech by US VP Pence highlights that trade tension is spilling into other areas.

The Australian property market

Australian dwelling prices have now fallen for 12 months in a row and more downside is likely in Sydney & Melbourne as a result of the combination of tighter bank lending standards, rising supply, falling price growth expectations feeding back to weaker home buyer demand and the possibility of changes to negative gearing and the capital gains tax discount if there is a change of government impacting investor demand.   We continue to expect these cities to see a top to bottom fall in prices of around 15% spread out to 2020 which given falls already recorded since last year implies another 10% or so downside. And if anything, the risks are on the downside. Falling home prices will drive a weakening wealth effect which along with still low wages growth and an 11 year low in the household saving rate suggests that retail sales growth will slow over the year ahead.

Against this back drop, it’s not surprising to see the RBA leaving interest rates on hold again this month. Yes, the RBA can point to the continuing global expansion, above trend GDP growth, an increase in the terms of trade and an improving labour market. But against this, uncertainty remains high regarding consumer spending, underemployment remains very high, the drought will have a negative impact, house prices are continuing to fall in Sydney and Melbourne, credit conditions have tightened, and wages growth and inflation remain very weak. Our view remains that the RBA will keep rates on hold out to 2020 at least and the next move in rates could still turn out to be a rate cut, given the risks around falling house prices and the threat this poses to consumer spending.

National capital city residential property prices are expected to slow further, with Sydney and Melbourne property prices likely to fall another 10% or so, but Perth and Darwin property prices at or close to bottoming, and Hobart, Adelaide, Canberra and Brisbane seeing moderate gains.

What to watch out for

In Australia, we will get an update on confidence and housing finance. Expect the September NAB survey (tomorrow) to show continuing solid business conditions but more subdued confidence, consumer confidence (Wednesday) to show a slight improvement after its August fall and housing finance (Friday) to show continuing softness in loans to property investors. The RBA’s Financial Stability Review will also be watched closely given the house price downturn and fears that tightening lending standards risks turning into a credit crunch partly in response to the Royal Commission.

Outlook for share market

We continue to see the trend in shares remaining up as global growth remains solid, helping drive good earnings growth and monetary policy remains easy. However, the risk of a correction over the next month or so still remains significant, given the threats around trade, emerging market contagion, ongoing Fed rate hikes and rising bond yields, the Mueller inquiry, the US mid-term elections and Italian budget negotiations. Property price weakness and approaching election uncertainty add to the risks around Australian shares.

And the Aussie dollar…

While the $A is now close to our target of $US0.70 it likely still has more downside into the $US0.60s 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. Being short the $A remains a good hedge against things going wrong in the global economy.

 

Risky business

Thursday, October 04, 2018

While US shares fell slightly over the last week, most major share market saw gains. Bond yields fell a bit in the US and Australia but rose elsewhere. Oil prices rose after OPEC left output unchanged, but metal and iron prices fell. The $US rose, particularly as the Euro fell on renewed Italian budget worries, and this saw the $A slip back to around $US0.72.

Although major global share markets performed well in September, defying seasonal weakness, Australian shares fell after reaching a 10-year high in August as defensives, consumer stocks, financials and high yield sectors came under pressure not helped by rising bond yields.

The heat is on

The trade threat from the US has not gone away. While markets saw a relief rally in response to the latest tranche of US/China tariffs being less than feared, it’s clear that the issue is far from resolved. The proposed fifth round of US/China trade talks didn’t happen. China has released a defence of its position and is going down its own path on the trade issue by announcing a cut to its average tariff to 7.5% from 9.8% and reducing non-tariff barriers and seeking to offset the impact of US tariff hikes by policy stimulus rather than engaging with the US on its gripes. And tensions between the US and China appear to be rising, with Trump accusing China of interfering in the mid-term elections and some low-level signs that military tensions may be rising too. Our view remains that while the tariffs actually implemented so far are relatively small, further escalation in the US/China trade conflict is likely, with a negotiated solution still a way off. Meanwhile, the risk is rising that Canada will not agree to a revamped NAFTA deal with the US, the US and Japan are now to enter new trade talks, with Trump clearly wanting concessions from Japan and French President Macron said he would not agree to a new EU trade deal with the US unless the US commits to the Paris climate agreement. Of course, Trump wants to get US allies on side so he can focus on China but there is still a long way to go on that front too. So trade will remain a periodic issue for markets.

US rates up, Aussie down

The US Fed provided no surprises, hiking rates by another 0.25%, describing the economy as strong and indicating that further gradual rate increases are likely. While the Fed is no longer describing monetary policy as “accommodative”, it’s far from tight either and Fed officials’ interest rate expectations (the so-called dot plot) point to rates rising above the Fed’s estimate of the long run neutral rate, which is currently at 3%. We expect another hike in December and, like the Fed, three more hikes next year. Market expectations for just over two more hikes over the year ahead remain too dovish. Continuing US rate hikes mean ongoing downwards pressure on the Australian dollar and the risk of more out of cycle rate hikes by Australian banks to the extent global borrowing costs rise. Trump’s criticism of Fed rate hikes are clearly not having any impact though with Powell indicating the Fed’s focus is keeping the economy healthy and that it doesn’t consider politics.

Republicans losing control

The issues around Brett Kavanaugh’s nomination to the US Supreme Court add to the risk that the Republicans will lose control of the Senate as well as the House. While this will not change our views around Trump and his economic policy – there is a good chance he will get impeached but there still wouldn’t be enough votes in the Senate to remove him from office and Congress won’t change or reverse his economic policies – it will be something that markets will worry about in the run up to and after the November 6 mid-terms.

Aussie property market

In Australia, the risks around house prices appear to be mounting and rising petrol prices pose a threat to consumer spending power. 

The risks around the housing market are continuing to mount, with more banks withdrawing from SMSF lending and signs of a crackdown on property investors with multiple mortgages, as the banks move to comprehensive credit reporting (i.e. sharing information on customer debts) and focusing on total debt to income ratios. The latter is significant, given estimates that nearly 1.5 million investment properties are held by investors with more than one property.

Credit growth to property investors remains very weak, as tighter lending standards and falling investor demand impact.

Source: RBA, AMP Capital 

Prices at the pump

Petrol prices over the last week have pushed higher on global oil supply concerns, with more upside likely as supply from Iran and potentially Venezuela is cut. The weekly Australian household petrol bill is now running over $10 a week higher than a year ago. So, while higher petrol prices (if sustained) will add to headline inflation, they will also cut into household spending power and dampen spending elsewhere which will keep underlying inflation down.

Source: Bloomberg, AMP Capital

For the RBA, these considerations largely offset each other for now so we see no reason to change our view that it will remain on hold for a lengthy period. I am even tempted to the RBNZ approach that the next move in rates “could be up or down”.

What to watch

The RBA will yet again leave interest rates on hold when it meets tomorrow. While recent economic growth and jobs data has been good, we are still waiting for inflation and wages growth to pick up and the slide in home prices risks accelerating as banks tighten lending standards, which in turn threatens consumer spending and wider economic growth. As a result it would be dangerous to raise rates and we don’t see the RBA hiking until 2020 at the earliest and still can’t rule out the next move being a cut. Meanwhile, on the data front expect CoreLogic data (today) to show another fall in home prices for September, August building approvals (tomorrow) to show a 2% bounce, the trade surplus (Thursday) to fall slightly to $1.4bn and retail sales (Friday) to rise 0.2%.

Outlook for share and property markets

We continue to see the trend in shares remaining up, as global growth remains solid helping drive good earnings growth and monetary policy remains easy. However, the risk of a correction over the month or so still remains significant given the threats around trade, emerging market contagion, ongoing Fed rate hikes, the Mueller inquiry in the US, the US mid-term elections and Italian budget negotiations. Property price weakness and approaching election uncertainty add to the risks around the Australian share market.

National capital city residential property prices are expected to slow further, with Sydney and Melbourne property prices likely to fall another 10% or so, but Perth and Darwin property prices bottoming out, and Hobart, Adelaide, Canberra and Brisbane seeing moderate gains.

 

Not going up

Wednesday, October 03, 2018

It’s getting hard to come up with anything new to say on this! But that’s as it should be, as raising rates just to get rates back to more “normal levels”, or so as to be able to cut them later if needed, would make no sense and would be bad for the economy. A premature hike would be akin to shooting yourself in the foot to be able to practice going to the hospital. (Sorry I know I have used that one before but couldn’t resist using it again!)

And don’t forget that official interest rates in Japan have been around zero for nearly 10 years, they have been around zero for around four years in Europe and they were stuck near zero for seven years from the GFC in the US. So just over two years at 1.5% in Australia is a non-event in terms of global comparisons.

On the one hand, the RBA can point to the continuing global expansion, above trend Australian GDP growth over the last year, an increase in the terms of trade and an improving labour market. But against this uncertainty remains high regarding consumer spending, underemployment remains very high, the drought will have a negative impact, house prices are continuing to fall in Sydney and Melbourne, “credit conditions are tighter than they have been for some time” and wages growth and inflation remain very weak. 

Given all these cross currents it remains appropriate for the RBA to leave rates on hold. And there remains nothing in the RBA’s latest post meeting Statement suggesting an imminent change in monetary policy. 

Our view remains that the RBA will keep rates on hold out to 2020 at least and the next move in rates could still turn out to be a rate cut given the risks around house prices and consumer spending, albeit this would not occur for at least another six months.

 

Is a property crash 60 minutes away?

Thursday, September 27, 2018

Australian data was light on over the last week but with the ABS confirming that home prices fell again in the June quarter. In terms of house prices, our assessment remains that the combination of tighter bank lending standards, rising supply, poor affordability and falling capital growth expectations point to more falls ahead, with Melbourne and Sydney likely to see top to bottom home price falls of around 15% out to 2020.

But what about the risk of a property price crash as suggested by the recent 60 Minutes report? Several things are worth noting in relation to this: predictions of a 30-50% property price crash have been wheeled out regularly in Australian media over the last decade including on 60 Minutes; the anecdotes of mortgage stress and defaults don’t line up well with actual data showing low levels of arrears; borrowers have already been moving from interest only to principle and interest loans over the last few years without a lot of stress; and the 40-45% price fall call on the program was “if everything turns against us”. Our view remains that in the absence of much higher interest rates, much higher unemployment or a multi-year supply surge (none of which are expected) a property crash is unlikely. But the risks are now greater than when property crash calls started to be made a decade or so ago and so deeper price falls than the 15% top to bottom fall we expect for Sydney and Melbourne are a high risk. This is particularly so given the risk that post the Royal Commission bank lending standards become excessively tight and if negative gearing is restricted and the capital gains tax discount is halved after a change in government in Canberra. There is also a big risk that FOMO (fear of missing out) becomes FONGO (fear of not getting out) for some.

One factor that supports the argument against a property price crash is ongoing strong population growth. Over the year to the March quarter, it remained high at 1.6%, which is at the top end of developed countries. As can be seen in the next chart net overseas migration has become an increasingly important driver of population growth in recent years.

However, there are a few qualifications to this: there is some risk that the migrant intake may be cut; while accelerating population growth in Queensland will support Brisbane property prices, population growth is slowing in NSW and Victoria so its becoming a bit less supportive of property prices in those states; and the supply of new dwellings has been catching up to strong population growth so undersupply is giving way to oversupply in some areas. The risk of the latter is highlighted by the continuing very high residential crane count which is still dominated by Sydney and Melbourne, indicating that there is still of lot of supply to hit the market ahead. Out of interest Australia’s total residential crane count alone of 528 cranes is way above the total crane count (i.e. residential and non-residential) in the US of 300 and Canada of 123! 

 

Is there a Democrat in the House?

Monday, September 17, 2018

The US trade threat has progressively increased all year, but every so often it takes a bit of a step back and that’s what occurred over the last week, with news that US/China trade talks may resume at the invitation of Treasury Secretary Mnuchin. Share markets reacted favourably, as they have to previous news of trade talks, but I wouldn’t get too excited. Talks are better than no talks, the latest round of talks, if they proceed, looks like they could be at a more senior level than the last round and it’s in the interests of both China and Trump to find a solution. In particular, Trump’s approval rating is under some pressure again, indications are firming that the Democrats will retake the House in the mid-term elections, business groups are reportedly mounting public campaigns against the tariffs and its now hard for the US to increase tariffs without causing higher prices for consumers, which in turn risks a backlash. So it would be wrong to write new talks off. However, given the failure of the last four attempted US/China trade negotiations to make much progress, and in particular Mnuchin’s last attempt back in May, it’s doubtful that much progress will be achieved this time. It may all just be a negotiating tactic on the part of the US to make it look like it’s reasonable and help build a coalition of allies against China. And in any case, Trump has reportedly issued instructions to proceed with the proposed next round of tariffs on $US200bn of imports from China despite the offer of talks. This could be more negotiating tactics, but who knows? All up, it does seem that both sides remain dug in and our base case remains that more tariffs will be applied (albeit the $US200bn may be implemented in tranches) and that a negotiated solution is unlikely until after the mid-term elections.

Notwithstanding the better trade news over the last week, we remain cautious of a short-term share market correction as we go through this seasonally weak part of the year and given risks around the emerging world, trade and tariffs, Trump and the Mueller inquiry and US political risks, Chinese growth and tech stocks.

In terms of US political risks, there is the threat of another government shutdown from October 1 when current government funding runs out again (yep, that issue is back again!) and the mid-term elections in November will create nervousness because if the Democrats get control of the House (as appears likely) investors will worry about an impeachment of President Trump and that it will put an end to major pro-market economic policies. On the last two: yes, the Democrats will probably try and impeach Trump but as with Clinton it’s unlikely that the 67 Senate votes will be found to remove him from office unless he has done something really bad and in any case Mike Pence will have the same economic policies but with just less noise; and Trump has already done the bulk of his pro-business policies (like tax cuts) anyway. None of this will stop markets worrying about it initially though.

The US remains in “Goldilocks” mode (not too hot, not too cold), with strong economic data and benign inflation. The past week has seen another run of strong data, with US small business optimism rising to its highest level ever recorded in August, job openings and hiring remaining very strong, the rate of workers quitting for other jobs rising to a 17-year high and jobless claims remaining ultra low. While retail sales rose less than expected in August, this was partly due to lower price rises and, in any case, previous months were revised up, so overall they remain very strong. Of course, the danger is that things can be so good that they are bad because the only way to go is back down – but at least inflation pressures (as a trigger for a more aggressive and growth threatening Fed) are not excessive, with producer and consumer price inflation actually dipping a bit in August. That said, with the US economy running hot and fiscal stimulus continuing, it seems there are more Fed officials saying the Fed Funds rate may have gone above its estimates of the long run neutral rate (between 2.5-3%) over the next year or so. Barring a blow up e.g. around trade or emerging markets, this looks highly likely but will take a while to play out at the ongoing rate of one Fed rate hike every three months.

Damage from Hurricane Florence is very unlikely to dissuade the Fed from its next hike later this month. While the human and property impact from such events is horrible, associated rebuilding activity will, if anything, boost overall economic growth in the short term. Hurricane Katrina in 2005 had no impact on Fed rate hikes that were coming every six weeks at the time.

Meanwhile, in the land down under…

Australian data was a mixed bag with strong jobs data and business conditions but falling confidence. 

Jobs, jobs, jobs…

Jobs data has been a source of strength in the Australian economy. The good news here is that full-time jobs growth has also been solid, this has helped reduce underemployment and strong jobs growth is an ongoing source of strength for household incomes. Against this though, the combination of unemployment and underemployment remains very high at 13.4% and points to the pick-up in wages growth being very gradual. 

What about interest rates?

Meanwhile, although the NAB business survey for August showed continued strength in business conditions, business confidence slipped further and September consumer confidence fell sharply, with political turbulence in Canberra and falling home prices in the case of consumer confidence not helping. Against this mixed backdrop, we remain of the view that an RBA rate hike is still a long way off.

Source: NAB, Westpac/MI, AMP Capital

Is the property market heading downhill?

ABS data due Tuesday is likely to confirm the slide in home prices already reported in private surveys for the June quarter with a decline of around 1%. The minutes from the RBA’s last board meeting (also Tuesday) is likely to reiterate that it expects that the next move will more likely be up than down but for now, there is no urgency to move. March quarter population data (Thursday) is likely to show continuing strong population growth.

National capital city residential property prices are expected to slow further, with Sydney and Melbourne property prices likely to fall another 10% or so, but Perth and Darwin property prices bottoming out, and Hobart, Adelaide, Canberra and Brisbane seeing moderate gains.

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

And the share market?

We continue to see the trend in shares remaining up as global growth remains solid, helping drive good earnings growth and monetary policy remains easy. However, we are now into a seasonally weak period of the year for share markets and threats around trade and emerging market contagion at a time of ongoing Fed rate hikes, the Mueller inquiry in the US, the US mid-term elections and Italian budget negotiations point to a potential correction ahead. Property price weakness and approaching election uncertainty add to the risks in relation to the Australian share market.

Low 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.

Where’s the Aussie dollar heading?

The $A is likely to fall to around $US0.70 and maybe into the high $US0.60s 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 bulk commodity prices should provide a floor for the $A though in the high $US0.60s. Being short the $A remains a good hedge against things going wrong in the global economy e.g. around trade and emerging markets.

 

Are we on the down side of the roller coaster ride?

Monday, September 10, 2018

The past week saw share markets fall on the back of worries around emerging markets, trade wars and the potential regulation of US social media stocks. After being resilient to global threats over the last few months, Australian shares also got hit and fell 3.1% to their lowest since June. 

While the iron ore price rose, oil and metal prices fell. 

The $A fell a bit further, despite the $US falling slightly.

This time of year is well known for financial market volatility and this year looks like it will be no different, with risks around the emerging world, global trade and tariffs, Trump and US politics, Chinese growth and tech stocks.

How bad is the EM crisis?

The emerging market crisis is continuing to ramp up, with emerging market shares in local currency terms down 14% from their January high and emerging market currencies down 16% since their February high, as investors fear other blow ups beyond Turkey and Argentina in emerging countries with current account deficits. 

Emerging market shares are cheap trading on a forward PE of around 11 times and are a good buy on a long-term view. Their decline so far is mild by the standard of past emerging market crises (e.g. they fell 27% in 2015-16) and they could easily fall further, as long as the US dollar remains in an uptrend (threatening debt servicing problems in the emerging world), Chinese growth continues to slow and the trade threat continues to ramp up. So far, the impact on advanced countries – via banks, etc. – has been minimal but as we saw in 1997-98, the deeper the EM crisis goes the bigger the risks.

Will there be a solution?

The US trade conflict still looks like escalating, with no breakthrough so far in US/Canadian negotiations increasing the risk that NAFTA will be terminated and more significantly the US moves towards implementing the next round of tariffs on China - up to 25% on $US200bn imports from China. If fully implemented, it will mean that around half of imports from China will be affected - albeit it’s only 10% of total US imports – so we’re still a long way from 1930. But it could still knock up to 0.5% off Chinese growth and maybe 0.1-0.2% off US growth. Some sort of negotiated solution is still likely but not until after the US mid-term elections.

How strong is global growth?

Our base case is that global growth will remain strong and that this along with rising profits and still easy monetary policy will keep the broad trend in share markets up, but these issues suggest a significant risk of a short-term correction in developed country share markets. So far, the US share market and until recently the Australian share market have shown little concern, but the Australian share market has started to come under pressure. And as we saw in the global growth scare of 2015-16, while the US share market remained resilient for a while in the face of falls in other global share markets, eventually it too came under pressure. Overall it remains a time for a relatively cautious investment strategy for investors with a short-term investment horizon. 

What's happening to rates here?

Back in Australia, the ANZ and CBA, as widely expected, followed Westpac in raising their standard variable mortgage rates all by an average 0.15% to recoup higher money market funding costs. This is a bit more than I would have thought, as the rise in funding costs on average looks to be around 0.09%. It’s a defacto monetary tightening equal to say a 0.25% RBA hike 15 years ago given the higher debt load. It will add to the weight on home prices and is another reason why the RBA won’t be raising rates any time soon.

How’s our growth going?

The Australian economy grew strongly over the year to the June quarter, but it’s likely to slow from here. June quarter GDP growth of 0.9% quarter on quarter or 3.4% year on year (as previous quarters were revised up) was much stronger than expected. Going forward, though declining building approvals point to slowing housing investment, falling home prices will weigh on consumer spending at a time when the household saving ratio is just 1% at a 10-year low, business investment growth is likely to be modest not helped by political uncertainty and there is also a risk that drought and US trade wars will weigh on growth. So while we don’t see a slump in growth we expect it to slow back to around a 2.5-3% pace this financial year. Other data released over the last week was consistent with this with retail sales stalling in July, ANZ job ads losing some momentum, housing finance continuing to trend down and the trade surplus falling back a bit. Business conditions PMIs generally remained solid though.

Down, down, house prices are down

According to CoreLogic, capital city prices fell another 0.4% and are down 2.9% from a year ago. Our assessment remains that prices in Sydney and Melbourne will fall another 10% as tighter bank lending standards, rising supply, falling capital growth expectations and fears of changes to negative gearing and the capital gains tax discount impact.

So while economic growth perked up last financial year, the RBA is expected to remain on hold as growth moderates again, wages growth and inflation remain low and given various threats to growth from falling home prices, drought and global trade threats. We remain of the view that the RBA will be on hold out late 2020 at least and still can’t rule out a rate cut.

And share markets?

We continue to see share markets being higher by year end, as global growth remains solid helping drive good earnings growth and monetary policy remains easy. However, we are now into a seasonally weak period of the year for share markets and rising threats around trade and emerging market contagion at a time of ongoing Fed rate hikes, the Mueller inquiry in the US, the US mid-term elections and Italian budget negotiations point to a potential correction ahead. Property price weakness and election uncertainty add to the risks in relation to the Australian share market.

Will house prices drop more?

National capital city residential property prices are expected to slow further, with Sydney and Melbourne property prices likely to fall another 10% or so, but Perth and Darwin property prices bottoming out, and Hobart, Adelaide, Canberra and Brisbane seeing moderate gains. 

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

What about the Aussie?

We continue to see the $A trending down 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 bulk commodity prices should provide a floor for the $A though in the high $US0.60s. Being short the $A remains a good hedge against things going wrong in the global economy – e.g. around trade and emerging markets.

 

Rates on the rise

Thursday, September 06, 2018

Australian mortgage rates are on the rise, with Westpac and some smaller banks moving and other big banks likely to follow. This was no real surprise, given the rise in money market borrowing rates this year, which has seen the gap between bank bill rates and the RBA’s cash rate blow out well beyond normal levels. While bank bill rates have fallen back a bit in the last month or so, the gap remains over 20 basis points higher than it has averaged over the last decade or so. Since banks get around 35% of their funding from this or related sources, it cuts into their margins, unless they pass it on in the form of higher lending rates.

Small banks had already moved and now it looks like the big banks are starting to follow – having delayed moving in the hope that the money market will settle down, which it hasn’t (and probably won’t, given slowing growth in bank deposits, meaning more competition for money market funds). While the rise in mortgage rates on average is small at around 15 basis points, it’s still another dampener on consumer spending and homebuyer demand, particularly given many borrowers will fear that more rate hikes will follow. It will hit the homebuyer market particularly in Sydney and Melbourne at a time when it’s already down. As such, it’s a de-facto monetary tightening and is yet another reason for the RBA to remain on hold for longer.

Source: Bloomberg, AMP Capital

The Reserve Bank is expected to yet again leave rates on hold when it meets tomorrow, which will bring it to a record 25 months in a row with no change. If growth and inflation picks up as the RBA expects, then a rate hike is likely at some point down the track but with downside risks around consumer spending, the housing cycle turning down in terms of construction and prices in Sydney and Melbourne and wages growth and inflation likely to remain lower for longer, we don’t see a rate hike until 2020 at the earliest and still can’t rule out the next move being a cut, particularly as falling home prices impact. A speech by RBA Governor Lowe (also tomorrow) is unlikely to signal any changes in the RBA’s views on monetary policy.

On the housing data front, expect CoreLogic to show another slight fall in home prices for August and housing finance data (Friday) to show continuing softness in lending to investors.

National capital city residential property prices are expected to slow further with Sydney and Melbourne property prices likely to fall another 10% or so, but Perth and Darwin property prices bottoming out, and Adelaide, Canberra and Brisbane seeing moderate gains.

What’s happening in the US?

While the past week saw pending home sales fall continuing the run of softer housing conditions, home prices continue to rise, consumer confidence is at a new 18-year high, personal spending is rising strongly with strong income growth keeping the savings rate high, jobless claims remain ultra-low and the goods trade deficit widened in July as imports picked up. Meanwhile core inflation rose back to the Fed’s 2% inflation target. All of which is consistent with ongoing but gradual Fed rate hikes.

 

Where in the bloody hell are we?

Thursday, August 30, 2018

The past week saw global share markets rise, as Turkey slipped out of the headlines, with US shares rising 0.9% to finally surpass their January high, Eurozone shares and Japanese shares up 1.5% and Chinese shares rising 3%. However, Australian shares fell 1.4% on the back of political uncertainty. The US dollar slipped as safe haven demand slowed, and this saw the $A rise slightly despite initially falling on the back of political turmoil.

Six PMs just like the Italians!

All the last four elected PMs have now been deposed by their own party and this is the sixth PM this decade, so we have now caught up to Italy. The turmoil is not great for Australia and has also seen investment markets start to get nervous about the coming Federal election. Of course, it’s dangerous to overstate the impact of the periodic bouts of leadership instability in Canberra seen this decade on the economy. It seems that as the “Lucky Country”, the economy still manages to muddle along, despite the mess in Canberra. I doubt that the latest leadership turmoil will change things that much. However, Australia should be able to do much better and the lack of durable leadership along with the problems in the Senate are making it harder to undertake serious productivity enhancing economic reforms and contributing to policy uncertainty, most notably around energy policy, which has led to world beating electricity prices.

Here are 4 implications from the latest change:

1. ScoMo win is reasonably good.

Firstly, he didn’t bring on the challenge so can’t be blamed for the instability. More importantly, he’s seen as a reasonably sensible policy maker, is respected by investment markets in his role as Treasurer and is seen as a centrist, giving the Liberals perhaps a better chance of victory in the coming Federal election. This probably explains why the share market and the $A had a bounce on the news that he will be the new PM.

2. Scope for tax cuts

While he will probably continue with the Government’s existing budgetary strategy, the abandonment of the policy to cut the tax rate for large companies along with the budget coming in a better than expected does provide scope for earlier and bigger tax cuts for low to middle income earners which could help economic growth.

3. More turmoil ahead?

The latest leadership turmoil and Scott Morrison’s relatively low margin of victory (of 45 to 40) still poses the risk that there may still be more turmoil ahead, all of which could weigh on consumer and business confidence just as it did under the last Labor Government.  The LNP victory in September 2013 provided a confidence boost as Australians looked forward to relative stability after the leadership turmoil of the Rudd/Gillard/Rudd years, but with instability clearly continuing confidence risks being eroded again. Business confidence is most at risk given the abandonment of the policy to cut the large company tax rate.

Source: Westpac/MI, NAB, AMP Capital

4. Timing of next election?

Finally, the leadership turmoil and Labor’s lead in opinion polls has focussed attention on the next Federal election and the likelihood of a change in Government. This has weighed on the share market and the Australian dollar over the last week. To keep Senate and House of Representative elections in alignment, the election needs to be no later than May but if the new PM sees a bounce in poll support, it could come before the end of the year. Labor’s main policies are increased public spending in areas such as health and education, lower taxes for low to middle earners but higher taxes for high income earners, halving the capital gains tax discount and restricting negative gearing for residential property going forward to new properties and it would possibly adopt a tougher regulatory stance in relation to the banks, energy supply and industrial relations. The tax cuts would provide a boost to consumer spending but the risk is that business confidence may dip, which could hit business investment and the housing market could take a hit from the negative gearing and capital gains tax changes at a time when it is already down. The latter (particularly if combined with cuts to immigration) risks resulting in a sharper top to bottom fall in home prices than we are assuming (a 15% decline for Sydney and Melbourne and 5% nationwide), which would be negative for banks and consumer spending.

As evident over the last week, political instability and more specifically uncertainty around a change of government is likely to weigh on bank, consumer and energy shares and possibly also the Australian dollar, as it risks adding to the forces already keeping interest rates down.

Reporting season nearly over

Source: AMP Capital

Source: AMP Capital

What to watch this week

The Australian June half earnings reporting season will wrap up, with 24 major companies accounting for around 5% of market capitalisation reporting including Spark Infrastructure (Monday), Caltex, Boral and Blackmores (Tuesday), Bellamy’s (Wednesday), Perpetual and Ramsay Health (Thursday) and Harvey Norman (Friday).

What’s ahead for markets?

While we see share markets being higher by year end as global growth remains solid, helping drive good earnings growth and monetary policy remains easy, we are likely to see ongoing bouts of volatility and weakness, as the US driven trade skirmish with China could get worse before it gets better and as worries remain around the Fed, President Trump in the run up to the US mid-term elections, China, emerging markets and property prices and election uncertainty in Australia. The August to October period is well known for share market falls and volatility.

We continue to see the $A trending down 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 bulk commodity prices should provide a floor for the $A though in the high $US0.60s. 

 

Always on my mind

Monday, August 20, 2018

Memories

The past week started downbeat on worries about Turkey but ended a bit more upbeat on news of new US/China trade talks. This saw US shares gain 0.6% for the week and Australian shares rise 1% to a new 10 year high, but Eurozone shares lost 1.5%, Japanese shares fell 0.1% and Chinese shares lost 5.2%. Bond yields were little changed although they are back above 3% in Italy as Italian budget negotiations come into focus. Commodity prices fell further, but the $US fell back a bit and this helped the $A make it back above $US0.73 after falling to near $US0.72 earlier in the week.

All shook up

Turkey got into this mess largely thanks to populist “growth at any cost policies” and its leader’s populist rejection of higher interest rates and an international bailout (for now) and refusal to make up with the US is helping perpetuate it. Financial assistance from Qatar will help but is unlikely to be enough. While Eurozone bank exposures to Turkey aren’t big enough to cause a major problem (they are mostly small relative to balance sheets and are likely to have been hedged) and global trade exposure to Turkey isn’t big enough either to cause a major problem and most other emerging markets are in far better shape both economically and politically, financial contagion remains a risk for emerging markets – with Brazil and South Africa most at risk. After a 14% fall, emerging market shares are now quite cheap (with an average forward PE of 11 times), but they are likely to remain under pressure until contagion fears from vulnerable EMs (notably Turkey at present) stop, the $US stops rising, uncertainty regarding Chinese growth fades and the trade war threat ends.

Suspicious minds

With China sending a delegation to the US at the end of this month for renewed trade talks at the invitation of the US, with talk of a Trump-Xi Jinping summit in November. Investors would be wise to be skeptical as to whether anything can be achieved quickly enough to head off US tariffs on another $US200bn of imports from China next month given that the May agreement was quickly trashed by Trump, that these negotiations are occurring at a low level officially and that both sides have dug in. Then again as we saw with Europe you never know, and most commentators seem to be skeptical of any break through and its in both sides interest to find a negotiated solution.

When it rains it really pours

We are now coming into the seasonally weak August-October period for shares and there are a lot of uncertainties around (Turkey/emerging markets, trade war threats, the Italian budget negotiations, ongoing Fed rate hikes, the Mueller inquiry and the US mid-term elections) all of which have the potential to trigger volatility and weakness in the next few months. This will likely impact both global and Australian shares.

It’s now or never

Should RBA lower inflation target from 2-3% to 1-2%? Short answer: NO! This debate comes up regularly and back in 2007-08 when inflation was around 4% some were arguing that the target should be raised. But lowering the target would be a bad move: it would give the impression that the RBA is not committed to its inflation target and just changes the goal posts when it’s not meeting it; a lower target would provide little buffer to slipping into deflation; it would mean less flexibility to take real interest rates negative when needed in a recession; and the consumer price index overstates inflation by around 2% or so given the problems in measuring quality change so running 1-2% inflation would imply actual deflation much of the time. If the argument is that by cutting the target the RBA can then declare victory on inflation and raise rates, then it’s a nonsense because by raising rates prematurely it would knock the economy and result in even lower inflation. If anything other countries should really be raising their inflation targets to 2-3% rather than the RBA cutting its target.

Elvis has left the building

August 17 marks the 41st anniversary of the day I and others in this time zone learned Elvis had apparently left the building. Back 50 years ago in 1968, Elvis had been working on what has become known as his Comeback Special. After years making lightweight movies (which I actually like, especially Live a Little Love a Little and Change of Habit which came in 1969) Elvis was feeling nervous. The Colonel wanted to end the special, which aired on NBC on 3 December 1968 with Christmas carols. But Elvis wanted something more relevant to the times so they came up with If I Can Dream - perhaps the most powerful social commentary song Elvis ever produced. It was recorded in June 1968 just two months after Martin Luther King’s assignation in Memphis and the song references King’s words. The Elvis in white suit delivery that wrapped the Special is well-known but it was also sung by Elvis in a black leather jumpsuit.

US mail

Retail sales rose strongly in July, industrial production was weaker than expected but June was strong, jobless claims remain ultra-low, the US leading economic indicator continues to rise strongly, small business optimism is very strong but while manufacturing conditions in the New York region strengthened in August they fell in the Philadelphia region. Housings starts rose less than expected in July, but home builder conditions remain strong.

Can’t help falling

For the June quarter Eurozone GDP growth was revised up to 0.4% quarter on quarter (or 2.2% year on year) but remains down from last year’s pace.

Shake, rattle and roll

Credit, retail sales and investment all slowed slightly in July and industrial production growth was unexpectedly flat. While the slowdown is not dramatic it suggests that the cut back in shadow lending and uncertainty around trade is weighing and supports the case for further policy stimulus.

What’s happening here in Oz?

Yet again Australian data was a mixed bag over the last week, with strong jobs data but continuing weak wages growth and somewhat softer readings on business conditions and consumer confidence. While employment fell in July, this was after a strong June, which itself was revised up and full-time jobs growth remained strong in July. Unemployment fell but this reflected a fall in participation. While annual employment growth is off its highs jobs leading indicators continue to point to solid jobs growth ahead. However, wages growth remained soft in the June quarter at 2.1% year on year and were it not for a faster increase in minimum wages it would still be stuck at just 1.9%. While strong employment is good news, it’s not enough to move the RBA from being on hold given ongoing high levels of underemployment, weak wages growth, falling house prices, etc. We remain of the view that the RBA will be on hold out to 2020 and there is still a significant chance that the next move will be a cut rather than a hike. RBA Governor Lowe’s Parliamentary Testimony did nothing to change our view on this.

Reporting season here

The June half Australian earnings reporting season is now around 35% done and so far so good. 48% of results have surprised on the upside compared to a norm of 44%, the breadth of profit increases is high with 83% reporting higher profits than a year ago compared to a norm of 66%, 89% have increased their dividends or held them constant and 64% of companies have seen their share price outperform the market on the day results were released. That said its often the case that the quality of results tails off in the last two weeks of the reporting season so don’t get too excited just yet. 2017-18 earnings growth are on track to come in around 9%, with resources earnings up 25% thanks to solid commodity prices and rising volumes and the rest of the market seeing profit growth of around 5%.

5 things to watch this week

1. In the US, expect the minutes from the Fed’s latest meeting (Wednesday) to confirm that it remains on track for another rate hike next month. The Kansas Fed’s Jackson Hole central bankers’ symposium (Thursday-Saturday) will also be watched for any clues on monetary policy, with Fed Chair Powell confirmed as a speaker (Friday). On the data front expect a modest rise in existing home sales (Wednesday), a continued increase in home prices and August business conditions PMIs (both Thursday) to remain solid at around 55-56 and July durable goods orders (Friday) to show a continuing rise. On the trade front a 25% tariff on $US16bn of imports from China is due to commence on Thursday – any delay ahead of new talks with China would be a positive sign.

2. Eurozone business conditions PMIs (Thursday) will be watched for any improvement from their recent levels around 54-55.

3. Japanese data is expected to show a slight improvement in inflation, excluding fresh food and energy to around 0.4% year-on-year, but it won’t be enough to move the Bank of Japan away from its ultra-easy monetary policy.

4. In Australia, the minutes from the RBA’s last board meeting (tomorrow) are likely to show the Bank remaining comfortably on hold. RBA Governor Lowe will also deliver a speech tomorrow. June quarter construction data is expected to show another modest rise and skilled vacancy data (both due Wednesday) will also be released.

5. The Australian June half earnings reporting season will see its busiest week, with 70 major companies reporting including Woolworths, Fortescue and Primary Health Care (today), Amcor, Oil Search and BHP (tomorrow), Seven Group, Worley Parsons and Coca-Cola Amatil (Wednesday), Qantas, South32 and Nine (Thursday) and MYOB (Friday). Dividend growth is likely to remain solid.

7 more things to keep an eye on

1. While we see share markets being higher by year end, as global growth remains solid helping drive good earnings growth and monetary policy remains easy, we are likely to see ongoing bouts of volatility and weakness as the US driven trade skirmish with China could get worse before it gets better and as worries remain around the Fed, President Trump in the run up to the US mid-term elections, China, emerging markets and property prices in Australia. The August to October period is well known for share market falls and volatility.

2. Low yields are likely to drive low returns from bonds. Australian bonds are likely to outperform global bonds helped by the relatively dovish RBA.

3. Unlisted commercial property and infrastructure are still likely to benefit from the search for yield, but it is waning.

4. National capital city residential property prices are expected to slow further as Sydney and Melbourne property prices continue to fall, but Perth and Darwin bottom out, and Adelaide, Canberra and Brisbane see moderate gains.

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

6. We continue to see the $A trending down 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. The fall in the $A on the back of Turkish contagion fears highlights that being short the $A and long foreign exchange is a good hedge against threats to the global outlook.

7. Eurozone shares fell 0.2% on Friday, but the US S&P 500 gained 0.3%. The positive US lead saw ASX 200 futures rise 28 points or 0.4% pointing to a positive start to trade for the Australian share market on Monday.

 

 

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