22 September 2017
Global share markets rose over the last week with Japanese shares up 2.5%, Eurozone shares up 0.7%, Chinese shares up 0.2% and US shares up 0.1%. However Australian shares were down 0.2% on rate hike fears and falls in the iron ore price. Bond yields rose as global data remained solid and the Fed continued its process of monetary tightening. Oil and metal prices rose but the iron ore price fell 12%. The A$ fell after Reserve Bank of Australia (RBA) Governor Lowe pushed back against talk of an early rate hike in Australia.
Bonds resuming their upswing as the Fed provides a jolt to investor complacency. A big surprise this year has been the extent of the pull back in bond yields in the US and to a lesser extent elsewhere, with a big driver of this being low US inflation and expectations that this will see less tightening from the US Federal Reserve (Fed). However, the Fed clearly sees things differently. Not only is it moving to start letting its holdings of bonds and mortgage-backed securities start to rundown from next month but it has also maintained its expectation for another rate hike in December. This is all understandable given the strength of US economic data and the likelihood that at some point this will start to push inflation up. So after hitting a low around 20% early this month the US money market’s probability of a December Fed rate hike has rebounded to 67%. And it’s hard to see a reduction in the Fed’s bond holdings not exerting some upward pressure on bond yields.
The bottom line is that while the Fed remains benign and gradual in undertaking monetary tightening, it’s not quite as benign and gradual as many had been assuming. This is likely to see further upward pressure on bond yields and the US dollar – after both sagged this year partly in response to lower than expected US inflation and expectations that the Fed may not raise rates as much as had been flagged. Equities should be able to withstand ongoing Fed tightening (short-term gyrations aside) because they are still cheap versus bonds. The Fed is only tightening because growth is stronger and US monetary policy is a long way from tight.
Of course, what Yellen and others at the Fed say comes with a bit less authority at present with Trump set to select the chair, vice chair and up to five governors (if Yellen also resigns her governorship if she does not remain as chair) in the next few months. But this is unlikely to slow the quantitative tightening process and the Fed could go either way on interest rates, so for now Fed commentary and the dots remain the best guide to its thinking.
Trump is still Trump – threatening to wipe out North Korea in the last week (but don’t forget to take him seriously, not literally!) – and I am not a political analyst (although economists like to pretend they are). But it does seem that Trump may have hit a low inflection point a few weeks ago in the aftermath of Spicer, Priebus, the Mooch and Bannon leaving the White House team and after Trump’s Charlottesville comments. Trump the pragmatist seems to be in control of Trump the populist, his White House team seems a lot more disciplined now and he is cutting pragmatic deals with Democrats and moderate Republicans to get things done. Some of this may be aimed at upping the pressure on the Republicans in Congress to get tax reform done (where progress is continuing). The hurricanes may have also helped but the sense of crisis around Trump looks to have receded a bit. Along with the Fed reasserting itself this adds to positives for the US dollar.
The German election saw Angela Merkel “win” but with her Christian Democrat-led coalition see less support than expected at a projected 32.5% of the vote.The Social Democrats (SPD) also got less support than expected at 20%. Clearly the migration crisis weighed with the far right Alternative for Deutschland (AfD) doing better than expected at 13.5%. The SPD leader has ruled out a return to coalition with Merkel so a coalition with the Free Democrat Party and the Greens is most likely, the negotiation of which will likely take months (as they usually do in Germany) but looks to be doable. Failing that Merkel will likely turn to the SPD which may be forced into another coalition as the alternative is a new election. The election result injects a bit of uncertainty into Germany but Merkel has already responded to the backlash on immigration and is likely to continue to do so. While her support was less than expected, it’s well up on where it might have been in the immediate aftermath of the crisis and after all the AfD did only get 13.5%. Provided immigration continues to come under control its unlikely there will be a major change of direction in Germany.
Major global economic events and implications
US data remains strong, abstracting from the impact of hurricanes. While August readings for home builders’ conditions, starts and existing home sales were all dampened by the hurricanes, permits to build new homes are up and initial jobless claims are already falling again. What’s more, the Markit business conditions PMI and manufacturing conditions in the Philadelphia region remained strong this month and the US leading index is also strong. Based on past experience the hurricane impact will be temporary and is best looked through.
Eurozone business conditions PMIs rose in September to very strong levels – with gains in manufacturing and services – pointing to stronger growth ahead.
UK PM May’s seeking of a two-year post Brexit transition with EU benefits and obligations would, if accepted by the EU, push out a Brexit cliff to 2021 and buy more time for a better deal. It would potentially support a more hawkish Bank of England and the British pound.
The Bank of Japan (BoJ) made no changes to monetary policy and remains on auto pilot, with quantitative easing and its zero target for the 10-year bond yield continuing until it gets inflation above 2% – right now we are a long way from that. With the Fed on track with tightening and the BoJ firmly on hold the Yen is in decline again which has helped Japanese shares rebound to their highest since 2015.
While China’s credit rating was downgraded to A+ from AA- by Standard and Poor’s (S&P) on the back of strong credit growth my view is that Chinese credit risks have declined a bit over the last year or so with stronger corporate earnings, reduced capital outflows and regulatory moves to slow credit growth. The S&P downgrade just follows a similar Moody’s downgrade in May. More broadly it’s odd to think that China is a huge creditor nation with a current account surplus, borrows from itself, saves too much (46% of GDP), consumes too little and has a weaker credit rating than Australia.
Australian economic events and implications
In Australia, the minutes from the RBA’s last Board meeting didn’t add anything new and nor did RBA speeches – but the latter still caused a few gyrations. While some may have been confused by the seemingly more upbeat comments of Assistant Governor Lucy Ellis and the more balanced comments of Governor Philip Lowe, it’s worth noting Ellis was mainly focussed on the global economy where it’s easier to sound more upbeat whereas Lowe was focussing on Australia where it’s more mixed. Lowe is upbeat about growth consistent with the RBA’s own forecasts but is well aware of the risks around wages and household debt and repeated that “a rise in global rates has no automatic implications for Australian rates.” We agree with Lowe that the next move in rates will likely be up but it’s still likely to be some time away.
For those who want to know “where the increase in jobs is coming from” the chart below shows a breakdown for the twelve months to August. Healthcare, construction and education are the big drivers.
In the US, a speech by Fed Chair Janet Yellen (Tuesday) will no doubt be watched for clues on the interest rate outlook but probably won’t add much to what we learned in the last week, i.e. that quantitative tightening is commencing and that the Fed still expects to raise rates again in December, however it’s contingent on economic conditions. Expect continuing modest gains in July home price data but a slight hurricane-related pull back in September consumer confidence (both Tuesday), a hurricane-related pull back in August pending home sales (Wednesday), continued strength in underlying durable goods orders (also Wednesday) but only a modest gain in August personal spending (Friday). Following recent CPI data, the August core private consumption deflator (Friday) may be a bit stronger at 0.2% month-on-month, but with the annual inflation rate remaining still low at 1.4%.
In Germany the focus will shift to the implications of the election result and speculation around the formation of a new coalition government . On the data front in the Eurozone, expect economic confidence readings for September (Thursday) to remain robust but core inflation to remain low at 1.2% year on year.
In Japan, expect August data on Friday to show continued labour market strength, solid growth in industrial production and some improvement in household spending but core inflation remaining depressed but rising slightly to 0.2% year-on-year.
Chinese business conditions PMIs (due Friday and Saturday) for September are likely to remain consistent with only a modest edging down in growth.
In Australia, March quarter population data (Wednesday) is expected to show population growth remaining strong at around 1.6% year- on-year led by Victoria, August ABS job vacancy data (Thursday) is likely to show continued strength and credit data (Friday) is likely to show continued moderate growth with a further slowing in property investor credit.
Outlook for markets
We remain in a seasonally volatile time of the year for shares, North Korean risks remain high and Wall Street is overdue for a decent 5% or so correction which would affect other share markets including the Australian share market. However, beyond short term uncertainties we remain in a sweet spot in the investment cycle – with okay valuations particularly outside of the US, solid global growth and improving profits but still benign monetary conditions – so we remain of the view that the broad trend in share markets will remain up. This should eventually drag the Australian share market up and out of the range-bound malaise it has been in since June.
Low starting point bond yields and a likely resumption of the rising trend in yields will likely drive poor returns from bonds.
Unlisted commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this will wane eventually as bond yields trend higher.
Residential property price growth in Sydney and Melbourne is likely to have peaked with a slowdown likely over the next year or two, but Perth and Darwin are likely close to the bottom, Hobart is likely to remain strong and moderate price gains are expected to continue in Adelaide and Brisbane.
Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.25%.
While further short term upside in the A$ is possible, our view remains that the downtrend from 2011 will ultimately resume as the Fed continues to tighten and the RBA holds into next year.