By Shane Oliver

The past week saw US shares rise 0.7%, European shares gain 2.6% and Japanese shares rise 1% helped by strong US forward looking data, signs that the Fed is increasingly confident in the US outlook and confidence that President Trump is in on track with his pro-business agenda.

By contrast, Australian shares fell 0.2% and Chinese shares fell 1.3%. Bond yields generally rose as the probability of a March Fed rate hike rose, and this also saw the $US rise slightly, which in turn put downwards pressure on some commodity prices and the Australian dollar, notwithstanding a reversal on Friday.

Despite much anticipation, President Trump’s Congressional address provided little detail on his pro-business policies, but he made plenty of references to deregulation, corporate and personal tax cuts and infrastructure spending and he sounded more presidential. As a result, share markets remained happy. Interestingly, the Trump administration also sent to Congress its trade policy agenda, which made reference to pursuing bilateral trade deals and renegotiating existing deals, but does not signal the widespread application of tariffs, which adds confidence to the view that a trade war will be avoided.  

The US Fed on interest rates

There was more interest in relation to the Fed, where comments by various Fed officials that it should move “soon” to raise rates again, and that the risks were “starting to tilt to the upside” (backed up by Fed Chair Yellen and Vice Chair Fischer) saw the money market’s implied probability of a March rate hike rise to 94%.

Given the run of strong US data and with Yellen, Fischer and New York Fed President Dudley confirming that a March hike is likely, we have moved our timing for the next Fed rate hike from May/June to March. If this were happening a year ago, share markets would have gone into a tailspin. But, because the US economy is stronger now, the Fed’s confidence in the outlook actually seems to be supporting the share market. After the strong gains since the US election, the likelihood of a short-term share market correction remains high. That said, the US share market seems to be following the pattern seen in previous rate hiking cycles, i.e. a pullback around the first hike (February 1994, June 2004 and December 2015) and then rallying into and through subsequent hikes because economic data is better. Back in the 2004-2006, tightening cycle rates were going up at every Fed meeting and it took 17 hikes to ultimately kill the bull market off.

A March hike would potentially open the door to four Fed hikes this year, but compared to the 2004-2006 rate hike cycle, this time around the tightening process is likely to be a lot slower reflecting still constrained GDP growth (so far March quarter growth looks like being below 2% again), still low wages growth and the strong and rising $US. Consistent with this, Janet Yellen indicated that she sees no evidence the Fed is behind the curve and continues to see rate hikes as being “gradual”, albeit faster than in the last two years.

Source: Bloomberg, AMP Capital 

Housing market risks 

The OECD is right to warn about Australian house prices, excessive household debt and the risk to the economy. Such risks are real, particularly with Sydney home prices up 73% over the last five years against wages growth of just 13%. Housing - both affordability and the nexus of excessive home price and household debt growth - remains Australia's Achilles heel. It's worth noting though, that such warnings have been issued continuously since 2003 and yet the property market keeps on keeping on. Our view remains that unit prices in some oversupplied areas will fall 15-20% at some point and that a 5-10% cyclical downturn in average home prices is likely once interest rates start to rise. But, it remains hard to see a generalised home price crash in the absence of: much higher interest rates causing a wave of defaults (but the RBA is not going to raise interest rates until it gets to that point); a surge in unemployment (of which there is no sign at present); and a continuing surge in supply (but building approvals look to have peaked). While the property market is proving even stronger than I thought, my views on the risk of a property crash are unchanged from those in this note.

Major global economic events and implications

US data was mixed – but where it counts in the forward looking indicators, it was strong. On the soft side, December quarter GDP growth was left unchanged at 1.9%, pending home sales fell, construction fell, real consumer spending fell in January and the trade deficit widened. But more importantly, consumer confidence rose to its highest since 2001, unemployment claims fell to their lowest since March 1973 and the ISM conditions indexes rose to strong levels near 58.  

In the Eurozone, economic confidence rose to a new six-year high, adding to the message from business conditions PMIs that growth is likely to accelerate. Meanwhile, headline inflation rose to 2% year-on-year in February on higher energy prices, but core inflation remained stuck at 0.9%. 

Japanese industrial production fell in January, but a rising trend in the manufacturing conditions PMI points to a rebound going forward. Labour market data was strong, but household spending was weak and core inflation remained low at 0.2% year-on-year – but at least it’s up from 0.1%. The BoJ remains a long way away from tightening. 

Chinese manufacturing conditions improved in February and services conditions held strong consistent with growth remaining solid.

Rising export momentum across Asia – with Korean exports up 20% year-on-year – is consistent with the stronger global growth theme. Even Indian GDP growth surprised on the upside in the December quarter, despite “demonetisation”.

Australian economic events and implications

The Australian economy saw some good news with December quarter real GDP rebounding by a greater than expected 1.1% quarter-on-quarter, robbing the doomsters from being able to declare a recession. The rebound in real growth was broad based across consumer spending, public demand, housing investment, business investment and trade. Nominal growth was also strong reflecting higher commodity prices which, in particular, supported profits. While growth will likely slow back a touch in the current quarter on slower consumer spending and trade, it’s likely to be close to 3% through 2017. In other data, the trade surplus fell sharply in January, but this looks to be due largely to temporary factors including the early timing of the Chinese New Year holiday and a slump in volatile gold exports. Building approvals rose slightly in January and new home sales fell slightly but the trend is down in both, pointing to a loss of momentum in housing investment. House price growth though stayed uncomfortably strong in Sydney and Melbourne in February according to CoreLogic, adding to RBA wariness about cutting rates again.

The Australian December half-profit reporting season wrapped up and left listed company profits on track for a 19% rise this financial year after two consecutive years of falls. The profit turnaround has all been driven by resources companies which are on track for a rise in profit of 150% this financial year, reflecting the benefits of higher commodity prices and volumes on a tighter cost base. Profit growth across the rest of the market is likely to be around 5% but it should accelerate in 2017-18 as economic growth improves.

What to watch over the next week?

In the US, February jobs data on Friday will be watched very closely as it’s the last major data release ahead of the Fed’s March 15 meeting. Payrolls are expected to rise by around 190,000 with unemployment falling back to 4.7% and wages growth edging up. Coming on the back of a run of solid data releases, this should keep the Fed on track for a rate hike on March 15. Meanwhile, expect the January trade deficit (Tuesday) to worsen slightly.

The European Central Bank is expected to make no change to monetary policy on Thursday. It has already committed to continue its €60bn a month asset buying program to year end and it’s premature to expect any announcement regarding a 2018 taper, particularly with risks around the French election and core inflation remaining well below target at 0.9% year-on-year. 

Chinese import and export growth for February (Wednesday) is likely to show a further acceleration, with imports up 18% year-on-year and exports up 14% year-on-year, and while CPI inflation (Thursday) is likely to drop back to 2% year-on-year, producer price inflation is expected to accelerate further to 7.5% year-on-year. The National People’s Congress that starts Sunday is likely to confirm a growth target of around 6.5% for this year.

The Reserve Bank is expected to leave interest rates on hold when it meets Tuesday. Economic growth bounced back nicely in the December quarter, recent economic data has been reasonable (particularly business conditions surveys), national income is rising again and growth in Sydney and Melbourne property prices is too strong for comfort. As a result, we expect the RBA to leave the official cash rate at 1.5% and we now expect the RBA to leave rates on hold for the rest of the year. Another rate cut is still possible, but it would require another leg down in inflation to get the RBA to cut again. On the data front, expect January retail sales (Monday) to bounce back by 0.4% after a slight fall but housing finance (Friday) to fall by 1.5%.

Outlook for markets

Shares remain vulnerable to a pull back as short term investor sentiment towards them is very bullish, the Fed is getting a bit more aggressive, Trump related uncertainty remains and various European elections could create nervousness in coming months. 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 rising profits.

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 is well behind the Fed in raising rates. 

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

National residential property price gains are expected to slow to around 3-4% this year, as the heat comes out of Sydney and Melbourne 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 Australian dollar could still see a retest of $US0.78 which, if broken, would likely see a run up to $US0.80. However, the downtrend in the $A from 2011 is likely to resume at some point this year as the interest rate differential in favour of Australia narrows (as the Fed hikes three or four times and the RBA remains on hold).

Eurozone shares gained 0.3% on Friday and the US S&P 500 rose 0.05% as Fed Chair Yellen and Vice Chair Fischer confirmed that another rate hike is likely at the Fed’s mid-March meeting, but with Yellen indicating that rate hikes will likely remain “gradual”. Following the slightly positive global lead, ASX 200 futures gained 0.4% pointing to a 21-point gain at the open for the Australian share market on Monday, reversing half of Friday’s 0.8% decline.