By Shane Oliver

The past week has been dominated by Brexit worries which pushed down most share markets and combined with a very dovish US Federal Reserve, pushed bond yields down as well. US shares fell 1.2%, Eurozone shares lost 2.4%, Japanese shares were also hit by the absence of further Bank of Japan monetary easing and fell 6%, Chinese shares lost 1.7% and Australian shares fell 3.7%. The fall in bond yields saw German 10-year yields fall briefly below zero for the first time and Australian 10-year bond yields fall briefly below 2% to a new record low. Commodity prices were mixed with oil down but metals up a bit. The Australian dollar was little changed.  

Source: Global Financial Data, AMP Capital

Why the Brexit frenzy and is it justified? The Brexit vote (Thursday) is fast approaching and nervousness in financial markets has been building over the last few weeks, particularly as the Leave campaign – focussing on the more emotive topic of immigration - has been showing a lead over Remain. The agitation in financial markets reflects two things. First, concern about the impact of Brexit on the UK economy via reduced trade access to the EU, its financial sector and labour mobility (which has been estimated at somewhere around -2% of UK GDP) and this has been weighing on UK assets, notably the British pound. But Britain ain’t what it used to be (eg it only takes 2.7% of Australia’s exports). The real concern globally is that a Brexit could lead to renewed worries about the durability of the Euro to the extent that it may encourage moves by Eurozone countries to exit the EU and Eurozone which in turn, could reignite concerns about the credit worthiness of debt issued by peripheral countries and lead to a flight to safety out of the Euro into the $US which could put renewed pressure on emerging market currencies, the Renminbi and commodity prices. And then we are back in the turmoil we saw earlier this year! 

However, with Eurozone shares falling 8% in the last few weeks, it could be getting overdone. If Remain wins then recent market moves should reverse with the British pound and Eurozone shares likely to bounce particularly sharply. If Brexit wins there could be more to go in the short term (ie shares down, bond yields down, British pound and Euro down and $US, Yen and gold up) but this will likely prove to be a buying opportunity in relation to European and global shares as Europe is likely to hang together as it did through its sovereign debt crisis. The hurdle for a Spain, an Italy or a France to leave the Eurozone is much higher than for the UK to leave the EU as they would end up with a depreciated currency and higher debt costs. Just think of Greece which despite all its woes consistently wants to stay in the Eurozone. In fact, support generally remains high for the Euro. It would probably also be the case that Europe would ultimately be better off without Britain as it would remove a brake on greater integration.

Will Brexit happen? While the polls have been moving in favour of the Leave campaign, I still lean to a Remain outcome: undecided voters are likely to favour the status quo, telephone polls which were more accurate in last year’s UK election still favour Remain and the murder of a pro Remain British politician by a mad Brexiteer may swing support back to Remain. 

Meanwhile, the Fed remains on hold and very dovish. It revised growth forecasts down fractionally to 2% for this year and next and slightly upgraded its inflation forecasts but it was a bit less positive on the US jobs market. More significantly the so-called "dot plot" showing expectations of the 17 Fed meeting participants for the Fed Funds rate still sees two hikes this year but six members now see only one hike this year (up from just one in March). The "dot plot" also lowered the profile for interest rates in the years ahead once again in the direction of already lower market expectations. See the next chart. Short of a big rebound in June payroll employment I can't see the Fed moving before September at the earliest. The key is that the Fed remains cautious and is allowing for global risks. Market expectations for a Fed rate hike this year now look too dovish (just 38% chance of a hike by December), but the key is that the Fed is not going to knowingly do anything that threatens the US or global growth outlook. 

Source: US Federal Reserve, AMP Capital

As if there isn’t enough to worry about, the terror threat loomed its head again with a horrible attack in Orlando. This appears to have more in common with the Sydney Lindt Café attack with another nutcase, but it doesn’t annul the horrible loss of life. Investment markets appear to be getting desensitised to terror attacks because if they don’t damage economic infrastructure, they are unlikely to have much financial impact. The Orlando attack has played into the hands of Donald Trump though.

Major global economic events and implications

US data remains consistent with a modest rebound in June quarter GDP growth. Industrial production was soft in May but manufacturing conditions in the New York and Philadelphia regions bounced back, the NAHB home builders’ conditions index rose and housing starts were stronger than expected, US retail sales rose strongly in May for the second month in a row and jobless claims remain low. The Atlanta Fed's GDPNow growth tracker is pointing to GDP growth of 2.8% annualised this quarter. Meanwhile, core CPI inflation was 2.2% year-on-year in May which is consistent with the Fed’s preferred measure of inflation slowly heading back to its 2% target.

The Bank of Japan disappointed yet again, but with inflation well below target, shaky growth and the Yen now rising to a 12-month high, pressure remains for additional quantitative easing which we still see being delivered, perhaps in July.

Chinese data for May was mixed with slowing growth in investment but stable growth in retail sales and industrialist production. Combined with stronger exports and stable business conditions PMIs growth looks to be tracking sideways at 6.5-7% but policy looks like it will have to remain stimulatory.

Australian economic events and implications

Australian data remains consistent with okay economic growth with business conditions remaining solid in May, consumer sentiment holding onto most of the rate cut related bounce in May and employment up solidly in May, with unemployment remaining unchanged at 5.7%. However, there are some concerns with business confidence down in May, full time employment growth remaining weak and labour market underutilisation as measured by unemployment and underemployment rising to a high 14.2% which will maintain downwards pressure on wages growth. So while growth looks okay, there is nothing here to prevent further monetary easing.

What to watch over the next week?

The focus in the week ahead will no doubt be on the Brexit vote (Thursday). Since polling stations won’t close until 10pm UK time on Thursday night, we may not get a clear indication as to the outcome until 7am the next day (around 4pm Friday in Sydney). If it’s a very close vote, it could take longer.  

The latest Spanish election (June 26) will also be watched closely. While opinion polls point to a stronger performance from left wing Podemos, following its alliance with a far left party, they also indicate neither a centre-left or centre-right coalition are likely to achieve a majority. The outcome may continue to be a minority centre-right government which won’t reverse the economic reforms of recent years, but will be constrained in what it can do. Fortunately most of the heavy lifting on Spanish economic reforms has already been done.

The German constitutional court will deliver its final ruling on the validity of the ECB's Outright Monetary Transaction program (Tuesday) which partly underpins Draghi's 2012 commitment to do "whatever it takes" to preserve the Euro.

In the US, the highlight will likely be Fed Chair Yellen’s Congressional Testimony (Wednesday) which is likely to repeat that the Fed remains dovish and cautious in raising rates. On the data front, expect a further gain in home prices and a rise in existing home sales (both Wednesday), but a fall back in new home sales and the June manufacturing conditions PMI to be around 50.5 (both Thursday) and underlying durable goods orders to show modest growth (Friday).

In the Eurozone, consumer confidence and business conditions PMIs (Thursday) will be released.

In Australia, the minutes from the RBA’s last meeting (Tuesday) will be watched for any guidance around the outlook for interest rates. On the data front expect ABS data to show a 1% gain in March quarter home prices (also Tuesday).

Outlook for markets

Short term event risk – the Brexit vote, Spanish election, Australian election, US Republican and Democrat party conventions - could drive continued short-term share market volatility. However, beyond near-term uncertainties, we still see shares trending higher this year, helped by relatively attractive valuations, ultra easy global monetary conditions and continuing moderate global economic growth. 

Lower and lower bond yields point to a soft to medium term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity and low inflation. That said, the recent bond rally has taken bond yields to ridiculously low levels, leaving them at risk of a sharp snapback.

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. 

A bounce from oversold levels and Fed rate hike delays are clearly supporting the Aussie dollar in the short term. But 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 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 rose 1.2% on Friday as Brexit fears receded a bit, but the US S&P 500 fell 0.3% led down by technology and health care shares. ASX 200 futures were unchanged, pointing to a flat start to trade for Australian shares on Monday.