Investment markets and key developments over the past week

          The past week saw geopolitics continue to cause gyrations in markets with political tensions around immigration in Germany and Trump upping the ante on trade with China and Europe. This saw most major share markets fall, with US shares down 0.9%, Eurozone shares down 1.9%, Japanese shares down 1.5% and Chinese shares down 3.8% and emerging market shares remaining under pressure. Australian shares bucked the global lead though. Safe haven demand saw bond yields mostly fall, except in Italy where worries resumed. The oil price rose 5.4% as OPEC agreed to increase output by 1 million barrels per day (which after production constraints probably amounts to about 0.7mbd) but which was less than had been expected. Gold, metals and iron ore prices fell. While the $A had a fall below $US0.74 it ended little changed over the week at $0.7436, with the $US index down slightly.

          Despite the trade war threat Australian shares rose 2.2% over the last week and made it to their highest level since early 2008, but is it sustainable?Australian shares have been boosted by a rebound in financial shares which had become oversold the previous week as bargain hunters snapped them up for their dividends, a boost to consumer stocks from the passage of the Government’s income tax package and strong gains in defensives and yield sensitive REITs. This has left the ASX 200 on track for our year-end target of 6300, assuming our base case of no major trade war is correct. However, the road between now and year end is likely to be rough with a high risk that the trade skirmish gets worse before it gets better, and worries around Trump, Fed rate hikes, China, emerging markets and Australian property prices all likely to cause a rough ride. Given that China takes one third of our exports the local market would be vulnerable should the trade war escalate significantly.

          Emerging markets under pressure but this is not 1997-98 all over again. From their highs early this year EM shares and currencies are down around 10%. The plunge reflects a combination of country specific problems (eg Turkey, Brazil and South Africa), concerns that the rising $US will cause a dollar funding crisis for emerging countries with significant $US debt, worries that they will be adversely affected by any global trade war and repositioning after investors loaded up on EM assets with a 65% rally in EM shares from early 2016 to early this year. The weakness could have further to go as many of these concerns remain, but it’s unlikely to be a rerun of 1997-98 or even 2015 as EM fundamentals around growth and external balances are arguably stronger than then and the rebound in the $US is likely to be limited.

          Trump’s further ramping up of the trade skirmish with China (from tariffs on $US50bn of imports plus another $US200bn should China retaliate and then another $US200bn if China retaliates to that) have significantly increased the risk of a full-blown trade war between the US and China - with a more significant economic impact. So far the bulk of the tariffs are just proposed so there is still room for a negotiated solution which remains our base case as that is what the US is seeking and China would prefer – otherwise the tariffs would have been implemented already. But there is now a high risk that some of the tariffs go into force before a negotiated solution is reached (which would be a short-lived negative for share markets), even though we still see the risk of a full-blown US-China trade war with deeper share market downside as being low at around a 10-20% probability. Key to watch for is the re-start of US-China negotiations ahead of July 6. Trump’s tweet threatening that the US will place tariffs on auto imports from Europe will further up the risk of a trade war with Europe.

          Expect measures to strengthen the Eurozone at its summit on Thursday and Friday, but will it be enough. Progress in this direction has been given a big push by French President Macron and German Chancellor Merkel supports many of his proposals. Expect progress on a banking union, measures to strengthen the European Stability Mechanism, possibly a start to a Eurozone budget, some agreement on an unemployment stabilisation fund and a strengthening of European Union border control enforcement. Solving the immigration issue is critical if Merkel is to head off a potential split with her Interior Minister who leads the Bavarian Christian Social Union and is threatening border controls around Germany and to keep Italy onside. A split with the CSU would unlikely spell the demise of Merkel or the German coalition Government as Merkel could get support from the Greens, but Merkel and her party would prefer to retain support from the CSU. A more integrated Europe would be positive for Eurozone assets including the Euro, but no progress would be bad.

          The Australian Government got a big win with the Senate passing its personal income tax package. However, the impact on consumer spending is likely to be trivial as the tax cuts for low and middle income earners don’t kick in until after taxpayers do next year’s tax return after June 2019 and are only around $10 a week which maybe buys two cups of coffee and the tax cuts for middle to higher income earners won’t be of any significance until next decade and just give back some bracket creep. So a surge in retail stocks on the news may have got a bit ahead of itself.

          Along with slow wages growth and falling house prices in Sydney and Melbourne there are two other drags on Australian households: rising petrol prices and potentially higher mortgage rates. The rise in petrol prices to around $A1.50/litre has pushed the typical Australian household’s petrol bill up by around $12 a week over the last two years.