By Shane Oliver

Shares were mostly soft over the last week. Chinese shares had a decent 4.1% gain, but US shares were flat thanks to a soft jobs report on Friday, Eurozone shares fell 2%, not helped by renewed Brexit concerns, Japanese shares lost 1.1% on disappointment about the lack of more fiscal easing and Australian shares fell 1.6% - weighed down by a fall in the iron ore price and worries that stronger than expected GDP growth means reduced prospects for RBA rate cuts.

Bond yields and the $US fell as weak US jobs growth in May is likely to further delay the next Fed rate hike, but commodity prices were mixed, with oil down but metals up. The Aussie dollar rose 2.5% mostly in response to the soft US jobs report. 

Weak US employment in May adds to the case for the Fed to further delay rate hikes. The May labour market report was much weaker than expected with payrolls up just 38,000 and wages growth stuck at 2.5% year-on-year. While unemployment fell to 4.7%, this was only because participation fell. This will unnerve the Fed and means that a June hike is likely now off the table with the US money market’s probability of June hike now back at just 4%. July remains our base case for the next hike but it would require a decent rebound in June payrolls, so the risk is now that the Fed will be delayed to September. However, while the May jobs report was a shocker and will impact the Fed, there is a danger in reading too much into it. As we regularly see in Australia, monthly jobs reports can be highly unreliable with occasional rogue results. Very low jobless claims tell us that the US labour market is still reasonably solid, so there is no reason to wheel out the recession fears again.  

Looks like I was too soon to speak of diminishing Brexit risks a week ago, with the latest round of polls seeing support for the “Remain” and “Leave” options converging again. Here are some key points on the June 23 Brexit vote: 

  • First, even if there is majority support to Leave it could be two years or so before the terms of the exit are agreed. 
  • Second, a victory for Leave would be seen as a negative for the UK given the threat it would pose to its access to EU markets, its financial sector and labour mobility. The size of this impact would depend on what sort of exit is negotiated with the EU but has been estimated at somewhere around -2% of UK GDP. This would adversely affect UK assets including the pound. Britain could in time agree on a trade deal with the EU (like Norway has) but this would involve a loss of sovereignty as Britain would have to agree to EU rules with no say in setting them. 
  • Third, the real issue (given the diminishing significance of the UK economy) would be perceptions of the impact on the Eurozone. A Brexit would not be of the same order as a Grexit because Britain is not in the Eurozone. But it could lead to renewed concerns about the durability of the Euro to the extent that it may be seen as encouraging moves within Eurozone countries to exit the EU and Eurozone (eg, a Frexit) which in turn could reignite concerns about the credit worthiness of debt issued by peripheral countries, lead to a flight to safety out of the Euro into the $US, which could in turn put renewed pressure on emerging market currencies, the Renminbi and commodity prices. All of which could trigger a bout of nervousness in global financial markets. Ultimately, the latter seems unlikely though, as it would more likely trigger increased pressure for integration in the Eurozone. Markets won’t know that initially though. 
  • Fourth, a Leave victory may be seen as reinforcing the anti-globalisation forces already evident globally. 
  • Fifth, while this sounds negative, a Brexit has been subject to constant debate lately and is seen as the biggest “tail risk” by fund managers according to a recent survey, so it should be at least partly allowed for. 
  • Finally, while the polls show the vote is close, it is notable that the Remain vote has had the edge over time and my assessment is that a majority of British voters will chose to stick with the status quo, much like the Scots did last year. So I attach a 70% probability in favour of Remain.

Has China really overinvested?

This seems to be taken as a given and then used to justify a bearish-forever view on commodity demand, comparisons to Japan, etc. But I am still a bit sceptical. Two things have particularly added to my scepticism lately. First, if the Chinese housing market really saw a massive over supply of housing with ghost cities etc, then why do Chinese property prices take off every time the regulators take the brakes off? Soufun's 100 city property price index rose 1.7% in May and is now up 10.3% year-on-year. Second, the following stats on the number of airports in each country caught my eye: the US 13,513; Canada 1,467; Russia 1,218; Germany 539; Australia 480 (must include little ones); China 507. Not much sign of an overinvestment in China here! And I suspect the same applies in relation to much of China's infrastructure. 

Australia's minimum wage is to rise 2.4% to $17.70/hour, but it's unlikely to have much macro impact as it only affects 15% or less of the workforce, so won't affect overall wages growth much. While Australia's minimum wage in US dollar terms was way above OECD country norms when the Aussie dollar was above parity, the 30% plus plunge in the $A means it's not as much of an issue now from a global competitiveness point of view. 

Major global economic events and implications

US data was mixed with strong April consumer spending, continued gains in home prices, a surprise rise in the May manufacturing conditions ISM index, low unemployment claims, a smaller than expected trade deficit and stronger than expected auto sales but soft payroll employment, a fall in services sector conditions and softer than expected construction spending and consumer confidence. Meanwhile, the core private final consumption deflator was unchanged at 1.6% year-on-year in April compared to the Fed’s 2% target and the Fed’s Beige Book observed “modest” economic and wages growth and “slight” price rises.

As expected the ECB remained in implementation and assessment mode at its June meeting, but the ECB’s continuing sub target inflation forecasts (1.6% for 2018) and President Draghi’s dovish comments indicate it retains an easing bias. Eurozone economic confidence improved for the second month in a row remains at levels consistent with continued okay economic growth, unemployment remained high at 10.2% and bank lending continued to increase modestly. Meanwhile, inflation ticked up slightly but core inflation at 0.8% year-on-year remains well below target.

As widely expected, Japanese PM Abe has delayed the scheduled second increase in its GST rate to October 2019, with “bold” fiscal stimulus likely to be announced in the months ahead. Meanwhile, labour market data for April was solid and industrial production rose, but it’s still trending down on a year ago and household spending remains weak.

Chinese May business conditions PMIs were flat or down slightly and remain up on recent lows, telling us that GDP growth is continuing to run along between 6.5-7%.

India remains a star performer globally with GDP up 7.9% over the year to the March quarter.

Australian economic events and implications

Australian data released over the last week was mostly strong with GDP much stronger than expected and up 3.1% year-on-year, building approvals rebounding back towards record levels, house price momentum picking up again led by Sydney, okay retail sales growth and the trade deficit continuing to contract. However, there were some soft numbers though with a fall in new home sales and mixed PMIs for May.

The bottom line is that thanks to a combination of booming resource exports as various projects complete (the third phase of the mining boom) along with a rebalancing of the economy towards consumer spending, housing and services, the economy is a long way from the much feared recession and there is no sign of one on the horizon.

However, there are some dampeners. Demand growth in the economy remains very weak with private final demand virtually flat; surging resource export volumes won’t create many jobs; nominal growth in the economy (at 2.1% year-on-year) is very weak, reflecting the commodity price slump and very low inflation; this in turn is weighing on profits; and meanwhile, the seeming return to boom conditions in the Sydney and Melbourne property market and another spike in apartment approvals poses an increasing risk of a property bust down the track.

Overall, our conclusion is that given the various cross currents, the RBA won’t be rushing into another rate cut in the months ahead but will cut again later this year. Meanwhile, if the renewed strength in home prices isn’t temporary expect a renewed round of APRA measures to slow mortgage lending.

What to watch over the next week?

In the US, a speech by Fed Chair Janet Yellen on Monday is likely to confirm that the chance of a June rate hike has been substantially reduced by the soft May payroll report in the US.

US data on job openings (Wednesday) and consumer sentiment (Friday) will also be released.

China's data for May will be released with exports and imports (Wednesday) likely to show a slight improvement and inflation data (Thursday) likely to show a further abatement of producer price deflation but CPI inflation remaining around 2.3% year-on-year. Growth in industrial production, retail sales and investment (June 12) is likely to be little changed from April. Credit data is expected to show a pick up from the softness seen in April.

Interest rates will again be the focus in Australia, with the RBA meeting Tuesday and likely to leave them on hold. While lower than expected wages growth for the March quarter and a still too high Australian dollar support the case for another rate cut to combat downside risks to inflation, solid real economic growth and the RBA's desire for "further information" after cutting last month is likely to see the RBA wait until August before cutting rates again. Meanwhile, expect ANZ job ads (Monday) to point to a softening trend for jobs growth, but housing finance for April (Wednesday) to show a 3% rise.

Outlook for markets

Significant event risk in the next month or so (Fed meeting, Brexit vote, Spanish election, Australian election) and the fear of “sell in May and go away, come back on St Leger’s Day” could drive an increase in short-term share market volatility. However, beyond 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. 

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

Capital city residential property price gains are expected to slow to around 3% this year, as the heat comes out of Sydney and Melbourne. Prices are likely to continue to fall in Perth and Darwin, but price growth is likely to pick up in Brisbane. 

Cash and bank deposits offer poor returns. 

After its fall from $US0.78 the Australian dollar is oversold and due for a bounce, which we may be starting to see. However, the bounce is likely to be limited and the longer term downtrend looks to be resuming 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 Australian dollar sees its usual undershoot of fair value.