By Shane Oliver

Investment markets and key developments over the past week

The past week saw share markets break higher helped by solid global economic data, good US earnings results and optimism that Donald Trump’s policies will help boost the US economy. In particular the US share market rose 1%, pushing it out of a range it has been in since mid-December and propelling the Dow Jones index above 20,000. Eurozone shares rose 0.5%, Japanese shares rose 1.7% and Chinese and Australian shares both gained 1%. Bond yields rose as did oil and metal prices. The $A fell slightly.

Not too much should be read into the Dow crossing 20,000. Yes it creates a bit of short term excitement (like crossing from Victoria into NSW) and generates some headlines but its really just an arbitrary number for an index which only has 30 companies that are combined using a ridiculous price weighting system (so that Goldman Sachs gets a bigger weight than GE). And there is no evidence of higher than average returns after each 1000 point level has been crossed on the Dow anyway.

President Trump and his team’s announcements and comments have continued to create uncertainty but the negatives (e.g., the US’s withdrawal from the TPP, arguments about “alternative facts” and the floating of a 20% border tax to pay for the wall with Mexico) have been drowned out by the positives (Trump’s reiterating of his commitment to deregulation and tax cuts, moves toward approving the Keystone XL and Dakota Access oil pipelines and the construction boost from building the wall with Mexico). So investors have been left to mainly focus on the positives. And it’s not just Trump - fundamental news has been good too with good US earnings results and continuing strong business conditions readings in the US, Japan and Europe in January. So the pause in share markets as investors digested the rally that occurred since the US election may have run its course.

Two issues regarding President Trump’s policies are worth a mention. First, the US withdrawal from the TPP is no surprise (it would not have passed Congress anyway) and its loss is hardly a disaster for Australia, particularly with other regional trade deals likely to fill the gap. The real issue will be if Trump embarks on a trade war with China…but it’s looking more like Trump will go down the path of negotiation as opposed to unilateral measures at least initially. Secondly, talk of a “border tax” is heating up in the US. Quite what this means is debatable with the US Congress proposing shifting corporate tax to taxing only the value added of goods consumed in the US such that imports are taxed but exports receive a rebate (much as occurs under value added taxes or GSTs). This is commonly referred to as a “border adjustment tax”. Trump initially called this approach too complicated and his “border tax” concepts have thought to have been more direct but his recent comments suggest he could be warming to the idea (or just waving a stick at Mexico). There is a long way to go but if it does get up it would be a huge boost for US exporters (eg Boeing) and a huge negative for importers (eg Walmart) and would put significant upwards pressure on the value of the $US. 

Italy’s Constitutional Court’s ruling on the electoral law for its lower house has refocussed attention on political risk in Italy explaining why its share market fell and its bond yields rose more than most over the last week. By ruling against a two round electoral system the risk that the populist Five Star Movement attains power is somewhat reduced but the pressure for an early election remains. On current polling another grand coalition would be the likely outcome of an early election, but the risk of a 5SM led Government will rise for a later election if the economy continues to perform poorly. But note that even if 5SM ultimately win’s it would first require a constitutional change to call a referendum on Italy’s membership of the Euro and in any case a majority of Italian’s support remaining in it. Of course that won’t stop markets from having bouts of Itexit fears 

Major global economic events and implication

US economic data was mostly strong. Home sales fell in December and December quarter GDP growth was only 1.9% annualised but trade detracted 1.7 percentage points and final demand was strong at 2.6%. Meanwhile, underlying durable goods orders were strong, business conditions PMIs rose further in January, consumer confidence rose to a new 13 year high, the leading index rose and home prices continue to rise.

The US December quarter earnings reporting season is also looking impressive. Roughly one third of US S&P 500 companies have now reported with 74% beating earnings expectations and 52% beating on revenue.  Earnings are now expected to be up 5% from a year ago taking them to a new high, which is up from an expectation of 3.6% yoy highlighting that the earnings recession that began in 2014 is long over.

Eurozone business conditions PMIs remained strong in January pointing to a slight acceleration in economic growth.

Japan’s manufacturing conditions PMI continued its recovery in January pointing to stronger growth. Inflation remained stuck around zero but does seem to have bottomed.

Australian economic events and implications

Low December quarter consumer price inflation in Australia is consistent with another RBA rate cut as inflation remains well below target, but it’s hard to see a move in February. Annual inflation at 1.5% year on year in December was in line with the RBA’s own forecasts and its likely to want to monitor the uptick in lending to property investors and see how the economy performs after its September quarter slump before cutting rates again. However, our assessment remains that with record low wages growth and ongoing spare capacity in the economy along with the increasing likelihood that low inflation is feeding on itself via falling inflation expectations it will take longer to get inflation back to target than the RBA is allowing. As a result we continue to expect another RBA rate cut around May.

Meanwhile a big rise in export prices saw the third successive rise in Australia’s terms of trade in the December quarter. This will boost national income which in turn will help real economic growth but in the absence of another leg up in commodity prices we have probably seen the best for now.

What to watch over the next week?

In the US, the Fed is expected to leave interest rates on hold on Wednesday. Fed Chair Yellen has continued to stress that rate hikes will remain gradual, not enough has changed since the last rate hike in December to justify another move just yet and the Fed is still awaiting clarity on the size of any fiscal stimulus that President Trump plans to deliver. Rather the focus will be on whether the post meeting statement implies more rate hikes than the three suggested back in December for 2017.

On the data front in the US the focus will be on the January manufacturing conditions ISM index (Wednesday) which is expected to remain strong and jobs data (Friday) which is expected to show a 170,000 gain in payrolls and unchanged unemployment at 4.7%. Inflation according to the core private consumption deflator (Monday) is expected to rise to 1.8% year on year, the employment cost index (Tuesday) is expected to confirm a slight increase in wages growth and consumer confidence (Wednesday) is expected to have remained high.

US December quarter earnings reports will continue to flow with over 100 major companies due to report.

In the Eurozone, December quarter GDP (Tuesday) is expected to show a slight acceleration in growth to 0.4% quarter on quarter or 1.7% year on year. Meanwhile, economic confidence data (Monday) is likely to have remained strong and headline CPI inflation (Tuesday) is likely to have risen further to 1.5% yoy but core inflation is likely to have remained flat at 0.9% yoy.

The Bank of Japan (Tuesday) is not expected to make any changes to monetary policy having committed in September to open ended quantitative easing until it exceeds its 2% inflation target, which at this stage remains a long way away. Japanese data on the labour market, household spending and industrial production will be also be released.

The Bank of England (Thursday) could announce that asset purchases will not be extended beyond February.

Chinese manufacturing PMIs will be released on Wednesday and Friday and are expected to show little change.

In Australia, the NAB business conditions index will be watched for an improvement after recent deterioration, but expect to see continued moderate growth in credit (all Tuesday), building approvals are likely to fall slightly and the trade balance (both Thursday) is likely to show an even larger surplus on the back of higher commodity prices. Core Logic home price data will also be released on Wednesday.

The Australian December half profit reporting season will get underway with a handful of companies reporting (including Downer Tabcorp and James Hardie). After 2 years of falling profits this financial year is expected to see a return to growth and the December half results are likely to confirm that. Steady earnings upgrades for resources stocks on the back of the rise in commodity prices has seen the consensus expectation for 2016-17 earnings growth rise to 16% from around 7% last September. Resource company profits are expected to more than double, but profit growth across the rest of the market is likely to be around 5% led by food producers and retailers, utilities, telcos and building materials companies. Key themes are likely to be: a massive turnaround for resources companies; constrained revenue growth for industrials with the September quarter economic slowdown not helping; continuing constrained revenue growth for the banks; and an ongoing focus on dividends and cost control.

Outlook for markets

The risk of a short term consolidation or correction in shares remains as sentiment towards them remains very high, President Trump could still throw a curve ball at markets and as we enter the seasonally weaker month of February. However, 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, some acceleration in global growth and the shift to rising profits in both the US and Australia.

Still low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds. Australian bonds are preferred to global bonds reflecting higher yields and as the RBA remains well behind the US in moving into a tightening cycle.

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

National capital city residential property price gains are expected to slow to around 3-4% this year, as the heat comes out of the Sydney and Melbourne markets and rising apartment supply hits.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.

The $A has had a short term bounce as the $US corrected from overbought levels. However, the downtrend in the $A from 2011 is likely to resume as the interest rate differential in favour of Australia narrows & it undertakes its usual undershoot of fair value. Expect a fall below $US0.70 but little change versus the Yen and Euro.

Eurozone shares fell 0.3% on Friday and the US S&P 500 dipped 0.1%. As a result of the softish global lead ASX 200 futures fell 0.2% pointing to around a 10 point decline in the Australian share market at the open on Monday morning.