By Shane Oliver 

Despite a positive start initially with US shares making it within 1% of an all-time high, share markets fell over the last week with increasing nervousness ahead of the June 23 Brexit vote particularly weighing on Eurozone shares. For the week Eurozone shares fell 2.7%, Chinese shares lost 0.8%, Japanese shares fell 0.3%, US shares fell 0.2% and Australian shares lost 0.1%. Expectations of an ongoing delay in Fed tightening and a flight to safety around Brexit fears pushed bond yields down and the US dollar up. Metal prices fell and while the oil price rose it gave up most of its gains later in the week. Although the Aussie dollar spiked higher after the RBA left rates unchanged it ended the week little changed.

Event risk is now looming large with notably the Fed meeting in the week ahead and more importantly, the Brexit vote on June 23rd. With Brexit polls now showing a swing in favour of a Leave vote, investment markets are starting to focus more on the risks around Brexit and the threat this poses to the British economy (with the British pound falling 1.4% on Friday) and to renewed worries about the stability of the Eurozone. All of which is seeing a flight to safety pushing bond yields down and the $US up. My view remains that undecided voters will stick with the status quo in the Brexit vote much as we saw in the Scottish referendum, but it’s a very close call.   

Will the decision by benchmark provider MSCI on June 14 on whether to include Chinese mainland (or A) shares in its emerging market and world equity benchmarks really have much impact on Chinese shares? Yes it could cause a near-term flurry of interest, but given that any inclusion will be phased in over time, the short-term impact may prove to be brief and marginal. Just like the Shanghai-HK share connect that generated much enthusiasm initially. Including Chinese A shares in global equity benchmarks over the very long term will boost foreign interest in Chinese shares which is good, but other drivers are far more significant in the short term.

The Fed is delaying again, and for good reason. After a brief flurry of heightened expectations for another rate hike soon, the Fed Chair Janet Yellen while upbeat and cautious at the same time, described low payroll growth in May as “disappointing” and “concerning” and dropped any reference to raising interest rates "in the coming months". So the prospect of a Fed rate hike in the week ahead looks very low (although maybe not quite the market's assigned probability of zero), the late July meeting looks too soon as there will only be one more monthly payroll report by then, so September looks more likely for the next move, but as we have seen for a long time now, the Fed has been consistently too hawkish on rates relative to market expectations.

In Australia, the RBA left interest rates on hold at 1.75% as expected. But its failure to reintroduce a comment something like "the low inflation outlook provides scope to ease rates further if necessary" into its post-meeting statement coming on the back of diminishing expectations for any imminent Fed rate, hike saw the Aussie dollar briefly push back to $0.75. This undid nearly half of its recent plunge from $US0.78 to a post rate cut low of $US0.7145. Talk of an easing bias is cheap and yet the RBA has made this mistake repeatedly over the last four years, which has only served to delay the adjustment in the Aussie dollar. Is the RBA done? Maybe, but I doubt it given the ongoing downside risks to inflation.

Along with the RBA, the Reserve Banks of New Zealand and India also left interest rates on hold in the past week, but the Korean central bank surprised with a rate cut to 1.25% and maintained an easing bias and the Russian central bank cut its cash rate by 0.5% taking it to 10.25%, indicating that global monetary conditions are still easing.

Which brings me to bond yields. How low can they go? Australian 10-year bond yields this week have hit a new record low of 2.09%. There are two key influences. First, the fall to record-low bond yields globally is seeing flows into bond markets still offering relatively high yields like Australian bonds, which in turn, drives their yields lower.

Australian bond yields at record lows

Source: Global Financial Data, Bloomberg, AMP Capital 

Locally the plunge in the cash rate is also impacting. Since the ten year bond yield reflects investor expectations of the average cash rate over the next ten years (along with compensation for locking your money away over time) and since such expectations tend to extrapolate current conditions off into the future the longer the cash rate stays low or falls further the greater the risk the bond yield will push into new record low territory catching down to bond yields in the US and much lower yields in Germany and Japan. The chart below shows the Australian 10 year bond yield against a 24 month trailing moving average of the cash rate which assumes that the cash rate remains at 1.75% for the next year. This would imply a sub 2% yield for Australian ten year bonds soon. In fact, if global bond yields continue to plunge the Australian bond yield could be below 2% in the next week or so. By year end we see bond yields being a bit higher, but the risks are on the downside.

Record low cash rates driving record low bond yields

Source: Bloomberg, AMP Capital

Major global economic events and implications

  • May US payrolls were disappointing but a new high in job vacancies and very low jobless claims tell us that labour demand remains strong and layoffs remain low.
  • Eurozone March quarter GDP growth was revised up to 0.6% quarter-on-quarter, telling us growth is continuing at a reasonable pace.
  • Japanese March quarter GDP growth was also revised up slightly to 0.5% quarter-on-quarter from 0.4%, which is good, but growth in Japan has been bouncing between negative and positive quarters suggesting it may not be sustained.
  • April machinery orders and May economic sentiment were both weak.
  • Chinese exports fell 4% year-on-year in May, which was in line with expectations, but the fall in imports moderated to just -0.4% year-on-year, which is indicative of higher commodity prices and possibly improved domestic demand. Meanwhile, consumer price inflation fell to 2% year-on-year but producer price deflation continued to abate which is a good sign.

Australian economic events and implications

  • Australian housing finance commitments fell in April led by a fall in investor finance, suggesting APRA measures continue to bite. Of course, this was before the May rate cut. Meanwhile, the MI Inflation Gauge fell in May, indicating disinflationary pressures may be intensifying in the June quarter.

What to watch over the next week?

In the US, the focus will be on the Fed (Wednesday) which is expected to leave interest rates on hold. A June hike was always unlikely, given the potentially disruptive Brexit vote taking place a week later, but disappointingly weak May employment data and a lack of urgency in comments from Fed Chair Yellen indicate a June move is very unlikely. Rather, the focus will be on the post meeting statement, Janet Yellen’s press conference, Fed economic forecasts and the so-called “dot plot” of Fed officials interest rate expectations, and while we expect the Fed to signal that it still sees two rate hikes this year, the overall message is likely to remain that it will be cautious in raising rates given low inflation and the uncertainties around growth. Given a likely desire to see clear evidence that US activity indicators and jobs have picked up, the Fed is more likely to wait till September before moving again.

  • Meanwhile on the data front in the US, expect to see solid growth in May retail sales (Tuesday), a fall in industrial production (Wednesday), core CPI inflation (Thursday) edge up to 2.2% year-on-year, the NAHB home builders’ survey (also Thursday) rise slightly but housing starts (Friday) fall slightly.
  • The Bank of Japan (Thursday) will be watched closely. After the disappointing lack of action at its last meeting the BoJ may now surprise the market, with additional easing particularly given that the G7 meeting in late May is now out of the way.
  • Chinese May data for industrial production, retail sales and fixed asset investment (Monday) is likely to show stable growth.
  • In Australia, expect the NAB business conditions index (Tuesday) to fall a bit, but the Westpac/MI consumer sentiment index (Wednesday) to hold recent gains. May jobs data (Thursday) is likely to show a decent gain, but watch the full time versus part-time mix which has been soft lately and higher participation may drive a slight rise in unemployment to 5.8%.

Outlook for markets

With US shares a bit short-term overbought from a technical perspective, significant event risk in the next month or so (Fed meeting, Brexit vote, Spanish election, Australian election, US Republican and Democrat party conventions) could drive a further increase in short-term share market volatility. However, beyond the risk of near-term volatility, we still see shares trending higher this year, helped by a combination of relatively attractive valuations, ultra easy global monetary conditions and continuing moderate global economic growth. 

Very low bond yields point to a soft medium-term return potential from them, but it’s hard to get bearish in a world of fragile growth, spare capacity and low inflation. This has been the story for most of this decade now!

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors. 

Capital city dwelling price gains are expected to slow to around 3% over the year ahead, as the heat comes out of Sydney and Melbourne thanks to toughening lending standards and pockets of oversupply. Prices are likely to continue to fall in Perth and Darwin, but price growth may be picking up in Brisbane. 

Cash and bank deposits offer poor returns. 

After its fall from $US0.78 the Aussie dollar became oversold and due for a bounce, which we have started to see. However, the bounce is likely to be limited, and the longer term downtrend looks likely to continue as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed eventually resumes hiking, commodity prices remain in a secular downswing and the Aussie dollar sees its usual undershoot of fair value. The dollar is still likely to fall to around $US0.60 in the years ahead.

Eurozone shares lost 2.5% on Friday and the US S&P 500 fell 0.9% as Brexit fears increased. The poor global lead saw ASX 200 futures lose 61 points or 1.1% pointing to a weak start to trade for the Australian share market next week.