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.