The past week was relatively quiet until Friday when the deepening crisis in Turkey triggered worries about contagion to European banks and emerging markets. This hit share markets resulting in Eurozone shares falling 1.3% for the week, US shares losing 0.3% and Japanese shares losing 1%. However, Chinese shares bounced 2.7% higher over the week and Australian shares gained 0.7%. Safe haven buying saw bond yields fall (except in Italy).

While the iron ore price rose, oil, gold and copper prices fell not helped by another rise in the US Dollar. The surge in the US Dollar saw the Australian Dollar fall to around $US0.73, its lowest since January last year.

The latest worries about contagion from Turkey as its currency plunged as much as 17% on Friday are likely overdone, but emerging market stress will remain for a while yet. Yes, there will be some impact on Eurozone banks that are exposed to Turkish debt (which will keep the ECB cautious), but it’s unlikely to be economically significant.

More fundamentally, Turkey is not indicative of the bulk of emerging countries. Its currency has crashed 42% this year because of current account and budget deficit blowouts, surging inflation, political interference in its central bank, economic mismanagement generally and political tensions with US following the imprisonment of an American pastor followed by US sanctions on Turkey including tariff hikes.

While Brazil, Argentina and South Africa also have particular problems, the rest of the emerging world is in far better shape. That said, emerging markets will remain vulnerable until the $US stops rising (given the impact a rising $US has on foreign debt servicing costs), the global trade threat ends and uncertainty regarding Chinese growth fades. And rising inflation pressures in the US – with core CPI inflation in July at its highest since the GFC - highlight that the upwards pressure on the $US will remain as the Fed is unlikely to stop its process of gradual rate hikes soon.

Friday’s breakdown in the Australian dollar out of its recent narrow trading range around $US0.74, is consistent with our long-held view that the $A is on its way down to around $US0.70. Friday’s fall in the Australian dollar also reminds that being short $A/long $US (or Yen) is a good hedge against threats to the global growth and share market outlook.

The drip feed of increasing tariff pressure on China continued over the last week with the US announcing that it will commence a 25% tariff on another $16bn of imports on August 23rd. This is no surprise though as it’s just the remainder of the initial $50bn they said they would do but only did $US34bn in July. So was China’s announcement of same sized retaliation.

So far there is still no sign of a return to negotiation and the likelihood is that it won’t happen until after the US mid-terms. Domestically there has been some criticism of President Xi Jinping’s handling of the trade issue with the US but his position is not threatened and there is little sign of him changing direction. The big one to watch will be next month when the US has threatened a 10% or 25% tariff on $US200bn of imports.

China’s proposed retaliation of an average 13% tariff on $US60bn of imports from the US is way less than proportional, begging the question of whether its backing down a bit or preparing to move into retaliation via other means as it runs out of imports to retaliate on – this could take the form of tougher taxation or regulation of US companies or maybe allowing the market to push the Renminbi even lower (although the PBOC has said it will not actively devalue the currency), which would then beg the question as to how the US might respond, e.g. more tariffs or maybe even intervention to soften the $US, i.e. “currency wars.” I don’t expect the US to intervene in the $US, but with Trump not interested in basic economics (or showing any awareness that his own policies have pushed the $US up) it’s a risk worth watching. The trade threat clearly has a long way to go yet.

Drought is increasingly becoming a significant threat to Australian growth. Flying to beautiful Townsville and back this past week I was struck by how parched much of the east coast of Australia looks thanks to drought. There has not been a lot of talk about its economic impact so far.

Most Sydneysiders don’t worry about drought until water restrictions are imposed, but because heavy rainfall earlier last year pushed Sydney’s catchment dams to 97% full, so far there has been no need for water restrictions. But total Sydney dams have now fallen to near 66% full and the national reality is that the drought is becoming a bigger threat. In fact, farm production has already fallen for each of the last four quarters.

Of course, agricultural production as a share of GDP aint what it used to be at just 2.5%. But a 25% slump in agricultural production as seen through past major droughts will knock 0.6 percentage points off economic growth. Unfortunately, summer weather forecasts don’t hold out a lot of hope for a quick end to the drought and it would be made a lot worse if another El Niño phenomenon arrived (with the Southern Oscillation index recently falling back from a mild La Nina to neutral). Of course, beyond a short-term boost to meat supply as farmers cut their herds, the drought will also provide a boost to headline inflation via higher food prices, but the RBA, will look through this given the dampening impact on underlying inflation from weak farm sector spending power.

Source: ABS, Bureau of Meteorology, AMP Capital

For fans of The Brady Bunch, the past week or so was an exciting one with NSYNC bass singer Lance Bass announcing he had won the bid for the family home, but then getting gazumped by Discovery Inc’s HGTV who want to use the house for a reality TV show. That said I thought The Brady Bunch was reality – it certainly inspired me to buy at various points a big Chrysler station wagon, and equal sized Pontiac convertible and later on a Brady Bunch style house. It also made it virtually impossible for me to go to sleep on an angry heart. The sale does highlight the magic of compound interest over many years, generating capital growth of at least 8% since the owners purchased it in 1973, and if it had been rented out with a net rental yield of 3.5% a total return of around 11.7% pa.

Major global economic events and implications

US labour market data remains strong with ultra-low jobless claims and ongoing very high readings for job openings, hiring and workers quitting for new jobs. Producer price inflation came in slightly weaker than expected in July but core producer inflation of 2.7% year-on-year implies ongoing upward pressure on consumer inflation and inflation as measured by the core CPI rose to 2.4% yoy in July, its highest since the GFC. All of which is consistent with continued gradual Fed rate hikes. Meanwhile, the June quarter profit reporting season is wrapping up on a strong note with earnings up around 27% on a year ago. With 90% of S&P 500 companies having reported, 83% have beaten on earnings by an average beat of 5.5% and 71% have beaten on sales.

Japan saw some good news on wages, with nominal wages growth lifting to 3.6% year-on-year in June, which is its highest in years. The very tight labour market with sub 3% unemployment may at last be leading to higher wages growth. That said, a sample change early this year may be a contributor, so the Bank of Japan will treat this cautiously. GDP growth also bounced back in the June quarter, albeit low at 1.1% yoy. Not so positive though were household spending, economic confidence and machinery orders. The overall impression is that Japan continues to grow but at a relatively constrained rate – which is not so bad given its falling population.

Despite the trade war threat, Chinese exports and imports came in stronger than expected in July. However, imports may have been boosted by a cut to Chinese tariffs. Meanwhile inflation readings were benign in July, indicating that inflation provides no constraint to further policy stimulus in China.

Australian economic events and implications

In Australia, the RBA provided no surprises in leaving rates on hold for a record two years, and given the cross currents in the economy, there is a good chance they could be on hold for another two years. The RBA’s largely unchanged forecasts in their Statement on Monetary Policy portraying a “favourable outlook” (in the words of Governor Lowe) of growth around 3.25% and a gradual rise in inflation along with strong infrastructure investment, rising business investment and strong export volumes are consistent with the next move in rates being a hike.

However the peak in the housing construction cycle, uncertainty about the outlook for consumer spending, the weakening Sydney and Melbourne property markets, the worsening drought, the risks that low inflation and wages growth will continue for longer and tight bank lending standards all indicate that the next move in rates could well be a cut.

So the stand-off continues, and the RBA will remain on hold for a while to come.

On balance, we agree with the RBA that the next move in rates will probably be a hike, but we are a bit less upbeat on growth, wages and inflation than the RBA, so any rate hike is unlikely to come until 2020 at the earliest and there is a rising risk that the next move will actually be down. Maybe the Reserve Bank of NZ is showing the way in noting that “The direction of our next [interest rate] move could be up or down”!

Meanwhile, housing finance commitments continued to soften in June, mainly driven by a  decline in finance going to investors which looks to reflect both supply as banks continue to tighten lending standards and demand as investors expectations for capital growth slide in response to falling prices, suggesting that a negative feedback loop between falling prices and falling investor demand may be developing.

The flow of June half profit results picked up a notch over the last week with okay but uninspiring results. So far 47% of results have surprised on the upside but 33% have surprised on the downside both of which are higher than average, 67% of results have seen profits up on a year ago which is around average, 71% of companies have increased their dividends from a year ago but a higher than normal 21% have cut them. That said, less than 15% of companies have reported so it’s too early to conclude much.