Share markets turned back down over the last week as inflation and Fed fears continued to ramp up on the back of Fed Chair Powell’s Congressional testimony not helped by President Trump’s announcement of tariffs on US imports of steel and aluminium The tariff announcement weighed a bit on the Australian share market with worries about the direct impact on Australian producers and the threat of a trade war, but as in early February it proved to be relatively resilient. Over the week US shares fell 2%, Eurozone shares lost 3.4%, Japanese shares fell 3.3%, Chinese shares fell 1.3% and Australian shares lost 1.2%. Bond yields were flat to down slightly helped by safe haven demand and commodity prices fell as did the Australian dollar.

We remain of the view that the pullback in share markets seen last month is a correction as opposed to the start of a major bear market, but we may not have seen the last of February’s share market lows. With US inflation and Fed expectations still moving higher and Trump adding to the inflationary pressure in the US with tariff hikes, share markets are likely to remain volatile in the short term with a high risk of seeing a re-test of February share market lows.

Trump’s intention to impose a 10% tariff on imported aluminium and 25% on steel, is bad policy at a bad time and will only add to the risk of a trade war. While not as bad as the 35% tariff on Chinese imports he talked about in the election campaign it’s still bad policy because tariffs don’t work - a review of the 2002 8-30% steel tariffs found “the costs of the Safeguard Measures outweighed their benefits”. And its bad timing because the US economy and labour market is already running hot. It doesn’t need more “help”. This will only add to production costs and inflation in the US and further increase the pressure on the Fed. In terms of whether we see a global trade war or not, China is the country to watch given that the US is also looking into taking action against it in terms of intellectual property, but apart from loudly protesting its likely to be relatively restrained in terms of retaliation preferring to work with other countries in mounting a WTO challenge and develop its image as the “good guy” in terms of supporting free trade. Out of interest only 1.6% of China’s steel exports and 16% of its aluminium exports go to the US (equal to a total of just 0.03% of its GDP) so the direct impact on China will be modest, which in turn should mean a relatively modest impact on Australian miners. Countries most exposed are Canada and Brazil. Australia is not a significant exporter of steel or aluminium to the US, but its vulnerable should a global trade war break out given the impact on our export markets like China.

Fed Chair Powell’s first Congressional Testimony was slightly hawkish. While Powell’s prepared comments were pretty balanced his answers to questions indicated he wasn’t concerned about a bit of market volatility and that he is leaning to four rate hikes this year. Since the December Fed meeting, which had three hikes in the so-called dot plot, global growth and US fiscal policy have become tailwinds to US growth and confidence in the US outlook has increased. The dots may not get to four at the March FOMC because it would require four of the six Fed officials currently on three hikes to move to four and recent comment from Fed officials has had a more cautious tone. But I think that’s where they are ultimately heading. Our view has long been and remains that the Fed will do four hikes this year (possibly five!). The Fed will still be “gradual” but just less gradual that it has been so far this tightening cycle as the strong growth and inflation outlook mean that it has more work to do to get back to a now rising neutral rate. So markets still have more adjusting to do with the US money market still only factoring in three hikes for this year. This adjustment won’t go in a straight line, but it means ongoing volatility as investors adjust to higher US interest rates and should be positive for the $US as the Fed continues to tighten ahead of other central banks.

Bank of Japan’s Kuroda starting to think about when to start thinking about how to exit easy money, but it’s a long way off yet. The BoJ expects inflation to be at its 2% target around 2019, so Kuroda’s comment that it will start thinking about exiting in fiscal 2019 isn’t that surprising. However, fiscal 2019 goes from April 2019 to March 2020 so it could be two years away before they even start thinking about it and in any case we have to get to 2% inflation first and the rising Yen will only make that harder.Which could in turn further delay the exit.

Europe is back in focus this Sunday (March 4) with the outcome of the vote by Social Democratic Party members on the coalition agreement with Angela Merkel and the Italian election. While it will be close, the SDP poll is likely to support the coalition because they won’t want the alternative which may be another election at a time when they are polling behind the Alternative for Deutschland. A yes vote would clear the way for Merkel to work with Macron to further strengthen Europe. A no vote may be a negative for Eurozone assets, but it could just see Merkel attempt to run a minority government.

The Italian election is a bit messier, with polling indicating that no single party or existing coalition will reach the 40% threshold to win government. Another grand coalition between Forza Italia and the Democratic Party or a centre-left coalition with the Democratic Party and the Five Star Movement would be the best outcome – but would only mean more of the same muddling along in Italy. A populist Euro-sceptic coalition between the Northern League and the 5SM would probably be the worst outcome but looks unlikely given their political differences. However, a populist right-wing coalition government including Silvio Berlusconi’s centre-right Forza Italia and the right wing Northern League looks marginally the most likely – but it wouldn’t be so good in terms of budget control and winding back reforms. The Italian election is unlikely to threaten an Itexit (an Italian exit from the Euro) in the short term, but it does run the risk of making Italy’s public finances worse than they already are with no progress in addressing Italy’s long-term competitiveness problems. Not great – but probably not enough to threaten the greater European integration agenda that Germany and France are likely to pursue (assuming SPD members back a coalition with Merkel). Assuming the outcome is another grand coalition, or a Forza Italia dominated coalition with the Northern League the market reaction is likely to be minimal.

Major global economic events and implications

US economic data was a mixed bag over the last week. Home sales fell in January with higher mortgage rates and reduced mortgage interest deductibility probably impacting, durable goods orders were softer than expected, consumer spending was soft in January and the trade deficit was worse than expected. December quarter GDP growth also got revised down slightly but this was due to weaker inventories with final demand actually very strong. However, against this consumer confidence rose to its highest since early last decade and household disposable income rose strongly in January pointing to a bounce back in consumer spending, the ISM manufacturing conditions index rose to boom time levels, jobless claims fell to their lowest since 1969 and home prices are continuing to rise. The core consumption deflator which is the Fed’s preferred inflation measure remained at 1.5% year on year in January but its been running around 2% annualised over the last six months and looks likely to head higher on the back of the strong economy. All of which supports the Fed in raising interest rates four times this year and highlights the danger Trump is running in terms of tariff hikes on top of fiscal stimulus.

The US December quarter earnings reporting season is now effectively done with profits up 16% for the year to December, earnings up 8% and expectations for profit growth this year revised up to 20.6%. Which is very supportive of shares, beyond uncertainties around the Fed and bond yields.

Eurozone economic confidence fell in February but remains very high consistent with strong growth, bank lending to the private sector is continuing to accelerate and unemployment fell further to 8.6%. Meanwhile, core Eurozone inflation was unchanged in February at just 1% year on year which will keep the ECB patient in terms of thinking about when to start removing its easy monetary policy.

Japanese industrial production fell surprisingly sharply in January, but the still robust manufacturing PMI indicates that it will bounce back. Meanwhile the labour market remains very strong with unemployment falling to the lowest since 1993.

Chinese business conditions PMIs were a bit confusing with falls in official PMIs but a small rise in the Caixin manufacturing PMI. Growth may be slowing in China, but only a touch.

Australian economic events and implications

In Australia, capital expenditure data provided more confidence that business investment has bottomed but the investment growth outlook remains soft. December quarter business investment was basically flat but with good growth in equipment and non-mining investment. The good news is that investment plans for both 2017-18 and 2018-19 were increased compared to those of a year ago. The disappointing news though is that the upswing in overall investment in prospect is modest as mining investment remains a drag (albeit a diminishing one) and its partly offsetting the improvement in non-mining investment. There is nothing here to bring forward RBA rate hikes. Other data was mixed with strong business conditions PMIs, moderate credit growth and another month of falls in house prices in February, driven by Sydney. Our assessment remains that Sydney and Melbourne property prices have more downside but that the total top to bottom fall will be limited to around 5-10% (with Sydney already down by 4.8%) in the absence of much higher interest rates or unemployment (both of which are unlikely).

Solid broad-based profit growth with a good outlook will help the Australian share market, but it’s still lagging global profit growth. The December half profit reporting season is now done and has been pretty good. 46% of results have exceeded expectations (against a norm of 44%), 74% of companies have seen profits rise from a year ago (compared to a norm of 65%) which is the strongest since the GFC and 66% have increased dividends from a year ago with 26% keeping them flat which is a sign of ongoing confidence in the outlook. Reflecting the reasonable quality of results 59% of companies saw their share price outperform the market the day results were released (against a norm of 54%). Consensus profit growth expectations for this financial year remain around 7%, with resources upgraded slightly to 16% and the rest of the market downgraded to 5% (from 6%) owing to a downgrade to banks. Profit growth expectations for 2018-19 have been upgraded to 5% (from 4%) thanks to resources. This is good news and will underpin a rising trend in the Australian share market. That said local profit growth continues to lag that globally where its running around 14%.

Source: AMP Capital

 


Source: AMP Capital

Source: AMP Capital

What to watch over the next week?

In the US, the focus will be on Friday’s jobs report for February and specifically whether we will see a further pick up in wages growth like we saw in the January report and which kicked off a plunge in share markets. Expect a 180,000 gain in payrolls, a fall in unemployment to 4% and wages growth unchanged at its January level of 2.9% year on year. In other data expect the February non-manufacturing conditions ISM index (Monday) to have slipped a bit but to a still strong level and the trade balance (Wednesday) to show a deterioration. The Fed’s Beige Book of anecdotal evidence (also Wednesday) will be watched for ongoing signs of building inflation pressure.

Both the ECB (Thursday) and Bank of Japan (Friday) are Iikely to remain on hold, basically staying on auto pilot for now with their ultra easy monetary policies. The ECB will be watched for signs of a taper in its quantitative easing program after September, but is likely to reiterate that rate hikes won’t occur until well after QE has ended which probably means around mid-2019. By contrast the BoJ is likely to reiterate that it has no plans yet to start winding back its ultra-easy monetary policy.

In China, the key to watch in the National People’s Congress that commences on Monday is the balance between growth and reform particularly around financial deleveraging. The 2018 growth target is expected to be around 6.5%, but if its looks like the focus is shifting more towards reform and financial deleveraging implying a greater tolerance for weaker growth then this could raise concerns about China’s growth outlook. I wouldn’t be too fussed though as the tolerance for lower growth is likely to remain low given the risks around social instability. Chinese trade data (Thursday) is expected to show continued solid growth in exports of around 10% but a slowing in imports to 15% and CPI inflation (Friday) is expected to rise to 2%yoy, with a further slowing in producer price inflation to 4%.

In Australia, the RBA (Tuesday) will leave rates on hold for the 19th month in a row. Solid business conditions and jobs growth along with RBA forecasts for stronger growth and inflation down the track argue in favour of a rate hike. But weak wages growth and below target inflation, risks around the outlook for consumer spending and the still too high $A argue for rates to remain on hold or to be cut. And the cooling in the Sydney and Melbourne property markets provide the RBA with plenty of flexibility. So the RBA is likely to remain comfortably on hold. We don’t expect a rate hike until late this year at the earliest. RBA Governor Lowe in a speech on Wednesday is likely to reinforce the impression that the RBA is comfortably on hold for now.

On data front in Australia, December quarter GDP data (Wednesday) is likely to show growth of 0.2% quarter on quarter or 2.2% year on year as net exports (due Tuesday) detract 0.7 percentage points from growth but this is offset by a bounce back in consumer spending and growth in business investment. Meanwhile, expect building approvals (Monday) to show a bounce after a big plunge in December, January retail sales (Tuesday) to show modest growth consistent with mixed to soft reports from retailers and the trade deficit (Thursday) to show an improvement to -$200m after a recent run of poor results.

Outlook for markets

Volatility in share markets is likely to remain high and we may see a retest of February’s share market lows, with investors yet to fully digest the outlook for higher inflation and interest rates in the US, but the broad trend in share markets is likely to remain up as global recession is unlikely and earnings growth remains strong globally and solid in Australia. We remain of the view that the ASX 200 will reach 6300 by end 2018.

Low yields and capital losses from rising bond yields are likely to drive low returns from bonds.

Unlisted commercial property and infrastructure are still likely to benefit from the search for yield by investors, but it is waning, and listed variants remain vulnerable to rising bond yields.

National capital city residential property price gains are expected to slow to around zero as the air continues to come out of the Sydney and Melbourne property boom and prices fall by around 5%, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.

After reaching as high as $US0.8136 in January which is near the top of the technical channel it’s been in since 2015, the $A is on the way back down again against the $US, and this is likely to get a push along as the gap between the RBA’s cash rate and the US Fed Funds rate goes negative this month. Solid commodity prices will provide a floor for the $A though.