By Shane Oliver

The past week saw share markets have a few wobbles in response to a somewhat more hawkish-than-expected Fed. European shares (up 1.7%) and Japanese shares (up 2.1%) continue to benefit from falls in the Euro and Yen along with good economic data too. Against this, US shares fell 0.1% (not helped by reports that a Chinese naval vessel had seized a US underwater drone), Australian shares fell 0.5% and Chinese shares lost 4.2% (not helped by the People’s Bank of China continuing to tighten liquidity and macro prudential controls). Thanks largely to the Fed’s more hawkish message, US bond yields continued to push higher, as did the $US. Commodity prices were mixed and the $A fell in response to the rising $US.

The more hawkish than expected Fed

Fed undertakes a somewhat hawkish hike. No one can claim surprise that the Fed hiked its key Fed Funds rate by 0.25% to a range of 0.5-0.75%. It had been well flagged and was easily justified by economic conditions. What surprised some though was a shift up in the median “dot plot” of Fed meeting participants’ interest rate expectations from two to three rate hikes in 2017 suggesting a more hawkish bias at the Fed and this drove a "risk off" reaction in markets.

There is a danger in making too much of this, as a year ago, the dot plot pointed to four hikes in 2016 and we only got one, so it’s hardly reliable and the post meeting statement and Fed Chair Yellen's comments were benign, but it does seem that the Fed is turning from somewhat dovish to somewhat hawkish. With the Fed at, or close to, meeting its objectives and fiscal stimulus, on the way we are also allowing for three rate hikes in 2017. 

Source: AAP

However, it’s way too early for US monetary tightening to be a cyclical negative for shares and growth assets, as monetary policy is still very easy and we are long way from any cyclical excess that presages an economic slowdown or recession. Meanwhile, the strong $US will continue to act as a brake on the Fed getting too aggressive in raising rates.

Although its early days, reports regarding the seizure of a US underwater drone in the South China Sea coming on the back of Donald Trump appearing to challenge the One China policy and his views on trade potentially signal a further rise in US-China tensions in 2017. While it should ultimately end OK, it could cause a bit of financial market volatility along the way.

What about Italy?

If you’re wondering what happened to Italy after the No vote and the PM resigned … basically a new government was formed, led by the same party (the Democratic Party) backed by the same coalition and with the same policies (except Senate reform). Only the PM and a few ministers have changed. So, an early election has been averted, and they may hang in there till the next elections are due in 2018. The next big event in Europe will be the elections in the Netherlands in March, where the Eurosceptic Party for Freedom may do well, but not nearly enough to form government.

India’s demonetisation coming to Australia?

It has been reported that the Government is considering removing the $100 note to crackdown on the cash economy. Of course, you won’t see your $100 bills become worthless, but to convert them to smaller denominations you may have to deposit them in a bank ... at which point the tax office could raise questions if there is a lot of them. It’s understandable the Government is upset at missing out on tax because of the cashless economy. But, such a move may not go down well with some who legitimately earned and paid tax on their notes but just don’t trust banks. India’s demonetisation experience also highlights that it runs the risk of short term economic disruption – but this should be much smaller in Australia where the cash economy is estimated to be around 1.5% of GDP compared to much more in India.

Major global economic events and implications

US economic data was mostly strong. Industrial production fell, retail sales were weaker-than-expected and housing starts fell 19%. But the weak retail sales followed two very strong months and the fall in housing starts followed a 27% gain in October and reflects volatility in multifamily starts. Meanwhile, gains in regional manufacturing indices and continued strength in the Markit manufacturing conditions PMI point to stronger manufacturing going forward. Small business optimism also rose strongly in November, and home builder’s conditions rose to their highest since 2005. And jobless claims remain low. Inflation readings were mixed, with a stronger rise in producer prices, but falls in import prices as the strong $US hit and core CPI inflation remained in the range it’s been in for the last year.

Eurozone business conditions PMIs remained solid in December, and continue to point to some acceleration in growth. 

Japan’s Tankan business survey and December manufacturing PMI showed improved conditions for manufacturers.

Chinese economic data for November was stronger-than-expected, with a pick-up in retail sales, industrial production and total credit suggesting that December quarter GDP growth may have picked up a bit from the 6.7% year-on-year pace.

Australian economic events and implications

Australian data was a mixed bag, with a fall in business conditions and consumer confidence, but a slight rise in business confidence and stronger jobs growth. A fall in consumer confidence was to be expected in December, following the weak September quarter GDP news, but the November jobs data was surprisingly healthy.

Yes, unemployment rose, but this was all due to higher labour force participation and monthly jobs growth was strong for the second month in a row with two months of strong full jobs growth. Leading jobs indicators such as job ads and vacancies point to reasonable jobs growth ahead.

Finally, Australians continue to see paying down debt and bank deposits as the wisest place for savings and remain sceptical of shares. The latter tells us that the share market is a long way from being over loved, which is a good sign from a contrarian perspective. Interestingly, real estate remains out-of-favour too.

Source: Melbourne Institute, AMP Capital

What to watch over the next week?

In the US, expect to see continued strength in November’s Markit services conditions PMI (Monday), a fall back in existing home sales (Wednesday), modest growth in underlying durable goods orders and personal spending, with inflation in the core private consumption deflator remaining unchanged at 1.7% year-on-year and home prices continuing to rise (all Thursday) and a bounce back in new home sales (Friday).

The Bank of Japan (Tuesday) is unlikely to make any major changes to monetary policy given the open-ended quantitative easing until it exceeds its inflation target that it adopted in September.

In Australia, the main focus will be the Mid-Year Economic and Fiscal Outlook budget update (Monday) where there is a risk of a further downgrade to the outlook for the budget deficit as lower wages growth offsets the beneficial impact of higher commodity prices. Quite how this pans out is dependent on what assumptions the Government adopts regarding key commodity prices relative to wages, but on balance we anticipate little change to the $37bn budget deficit projected in May for this financial year, but $10bn or so added to the deficit in the subsequent three years, but with the Government still projecting a return to a wafer-thin surplus by 2020-21. In terms of economic assumptions for this financial year, expect real GDP growth to be revised down to 2.25% (from 2.5%) and wages growth is likely to be revised down to 2% (from 2.5%). To offset the further deficit blow out, the Government is likely to announce various savings (eg, abolition of the Green army, more tax revenue from the cash economy). Overall, the MYEFO may not be enough to trigger a rating downgrade immediately, but I think whether it’s in the week ahead, or after the May Budget, a downgrade is just a matter of time. This would be a huge psychological blow to Australia, but I doubt that it will have a lasting impact on bond yields or borrowing costs. 

Source: Australian Treasury, AMP Capital

Meanwhile, the Minutes from the last RBA Board meeting (Tuesday) are likely to confirm that the RBA retained a neutral bias on rates. But these Minutes will be very dated, given the subsequent news of a fall in September quarter GDP.

Outlook for markets

Shares remain overbought and are vulnerable to a short-term pullback with potential triggers being uncertainty about what Donald Trump will do, US-China tensions, the sharp back up in bond yields and the strong $US. However, any correction may not come until the New Year given normal seasonal strength (the Santa rally) into year end. And we see share markets trending higher over the next 12 months helped by okay valuations, continuing easy global monetary conditions, fiscal stimulus in the US, moderate economic growth and the shift from falling to rising profits for both the US and Australia. 

Sovereign bonds are now very oversold and due for a short term pullback in yield. This is particularly the case in Australi, where 10-year bond yields at 2.9% look out of whack with the likelihood that the RBA will cut rates again next year, or at the very least, won’t be raising them until 2018 at the earliest. But on a medium-term view still, low bond yields point to a poor return potential from bonds and the abatement of deflationary pressures as commodity prices head up, the gradual using up of spare capacity and a shift in policy focus from monetary to fiscal stimulus indicates that the long-term decline in yields since the early 1980s is probably over. So expect the medium-term trend in bond yields to be up. 

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors, but this demand will wane as bond yields trend higher over the medium term. 

Dwelling price gains are expected to slow, as the heat comes out of Sydney and Melbourne and as apartment supply ramps up, which is expected to drive 15-20% price falls for units in oversupplied areas into 2018.

Cash and bank deposits offer poor returns. 

A shift in the interest rate differential in favour of the US as the Fed remains on its path to hike rates should see the long term trend in the $A remain down.

Eurozone shares rose 0.3% on Friday, but the US S&P 500 fell 0.2% following reports that a Chinese naval vessel had seized a US underwater drone in the South China Sea. Following the mixed global lead, ASX 200 futures fell 0.1% on Friday night so I expect the Australian share market to open down around 5 points on Monday morning.