Investment markets and key developments over the past week
It’s been a good news week on the geopolitical front with the outlines of a mini-trade deal between the US and China and signs of progress on Brexit. Share markets were whipsawed through the early part of the week on conflicting reports regarding prospects for the latest US/China trade talks but then rallied sharply as a deal came into view. This saw US shares rise 0.6% for the week, Eurozone shares gain 1.8%, Japanese shares rise 1.8% and Chinese shares gain 2.5%. Australian shares also rose 1.4% led by health, telcos, IT and industrial shares. Trade talk optimism also pushed bond yields sharply higher and oil and metal prices up, although the iron ore price fell. The oil price was also boosted by an attack on an Iranian oil taker (but note that the oil price is just where it was before the attack on Saudi Arabia – so there is no excuse for another dodgy spike in Australian petrol prices!). The Australian dollar rose slightly as the US$ fell.
The US and China reach agreement on the outlines of a mini trade deal. This was about the best that could have been expected. The details are pretty vague but key elements involve China buying more US agricultural products and making some commitments around IP protection, financial services and currency in return for the US suspending the October 15 tariff hike from 25% to 30% on US$250bn of imports from China. President Trump says it’s the first phase of a broader deal. The details still need to be finalised and signed off by both sides and based on the experience of the last 18 months it could still turn pear shaped again. The public and political response to the deal in the US along with Trump’s response to that will also have to be watched. However, the mini deal has come as the pressure on both sides to solve the trade issue – from deteriorating US and Chinese economic growth prospects, China’s need for some US agricultural products & President Trump’s desire to sell them, and Trump’s desire to announce a win in the face of impeachment pressure – is now intense. There is a long way to go to reach a broader deal covering all of the issues but the mini deal highlights that the pressure to resolve the issue is now impacting. This pressure will only intensify next year as the US presidential election approaches with Trump wanting to avoid an economic downturn at all costs. Assuming its fully ratified and enacted, the mini trade deal is positive for shares, commodities and other growth assets but a negative for bonds where yields are increasingly looking Iike they have seen their cyclical lows. Uncertainty around trade will remain high causing bouts of volatility in investment markets but there is now a good chance that we have seen, or are getting close to, peak trade war angst.
Meanwhile, in a sign of the pressure that has been building on President Trump his tweet rate has gone through the roof over the last month with 797 in September – a rate of 26.6 tweets per day!
Fed still on track for more easing and will resume balance sheet expansion. Comments by Fed Chair Powell were notably dovish characterising the current period as a mid-cycle slowdown but noting that the Fed is data dependent with “a healthy dose of risk management.” He also made no effort to push back against market expectations for further easing and said that he wanted to see inflation “moving symmetrically around 2%” which sounds like Australia’s approach to inflation targeting. It’s all consistent with another Fed cut on the way later this month, despite the announcement of a mini trade deal. What’s more Powell confirmed and the Fed subsequently formally announced that it will resume growing its balance sheet by buying short term Treasury bills initially at the rate of US$60bn a month for the next six months to boost the level of reserves in the financial system to help avoid problems in the short-term money (or repo) market as seen lately. This is not really an additional monetary easing – because it’s just aimed at keeping the repo market operating properly and the Fed Funds rate at target (which is probably why it was announced outside of regular Fed meetings) – but some may see it as such.
Progress on a Brexit deal at last with the UK and Irish PMs reportedly seeing a pathway to a deal on the “Irish backstop” and EU officials sounding more positive as PM Johnson indicated he was prepared to make concessions. Most commentary around the so-called Irish backstop is very confusing. The problem is that to preserve the integrity of the EU customs union either: (1) all of the UK needs to remain in it, (2) all of Ireland needs to remain in or (3) a hard border is put up between Ireland and Northern Ireland. Brexiteers don’t like option 1, option 2 would break up the UK and is not liked by Northern Ireland unionists and option 3 would take Ireland back to the “the troubles” and is not supported by Ireland and the EU. But if there is no agreement on how the border between Northern Ireland (ie the UK) and Ireland (ie the EU) is treated then a transition deal (that sees the UK retain existing relations with the EU through an up to three year transition period after which a final solution is worked out) won’t be reached and there will be a no-deal Brexit which would mean an abrupt end to free trade between the UK and EU which in turn would be a huge blow to the UK economy given 46% of its exports go to the EU. The current deadline for Brexit is 31 October but if a deal is not reached and ratified by 19 October then the UK parliament has required PM Johnson to request another extension which probably means a new election or maybe another referendum. Either way a no deal Brexit is looking unlikely.
In Australia, debate about whether the RBA will or should do quantitative easing is hotting up. Our assessment is this. First, achieving decent growth nearer 3%, full employment and the inflation target is unlikely on current policy settings. Second, while rate cuts are having a diminishing stimulatory effect on the economy (as the banks are passing less of them on) it’s still positive and the RBA is likely to want to exhaust them before it moves onto unconventional monetary policy. This probably means cutting to 0.25% (with another cut next month or December and then another in February). Third, there is little point going to zero or negative as banks won’t pass it on and it will just scare people but the RBA likely will tighten its forward guidance along the lines of “we don’t plan to raise rates until inflation is approaching 2.5%”. Fourth, fiscal policy should be eased with a roughly 1% of GDP package focussed on investment allowances, a bring forward of infrastructure spending and support for households but this may take a while to come through. So, in the meantime the pressure will remain on the RBA, which is likely to respond early next year with a quantitative easing program which will involve using printed money to buy government bonds and private securities. This is not ideal and its boost to the economy will be limited as Australians borrow based on short term rates whereas QE will depress long term yields. But the RBA has a mandate and its not to do nothing. Ideally fiscal stimulus and QE should be undertaken together, with the former providing a more assured and more equitable boost to growth and the latter helping to shore up inflation expectations. (Note that the provision of cheap funding to banks from the RBA in the event of a financial crisis is a form of QE but it’s not really an issue at present as banks are not facing difficulties in terms of funding – but it may be a way for the RBA to ensure that cash rate cuts are passed on to lower mortgage rates.)
Major global economic events and implications
US data was light on but showed a fall in small business confidence and a decline in job openings. Both are still strong and there are still more job openings in the US than there are unemployed workers (see the next chart) but the risk is that openings and small business confidence will follow the business conditions indicators like the ISM indexes down.
So far there is no sign of weakness in US jobless claims though which remain ultra-low. Meanwhile, both producer price and consumer price inflation were benign in September with producer price inflation continuing to fall pointing to declining inflation pressure. This in turn provides the Fed with plenty of flexibility for further rate cuts.
Japanese data showed continuing weak wages growth, but a better than expected rise in household spending and a rise in economic confidence.9
Australian economic events and implications
Australian economic data was a mixed bag. On the on hand economic confidence was soft with a further slight fall in business confidence according to the latest NAB business survey and a sharp fall in consumer confidence to its lowest since 2015 according to the Westpac/MI consumer survey. News of rising unemployment, talk of recession, slow growth, global weakness, share market falls and rising petrol prices last week when the survey was taken probably all weighed on consumer confidence. ANZ Job Ads rose slightly in September but this was after a sharp fall in August & they are down 10.4% from a year ago consistent with slower jobs growth ahead.
Against this, housing finance commitments continued their recovery in August with a strong rise in investor finance adding to evidence from clearance rates and sales of an upturn in the property market. However, once again it looks pretty narrow led by NSW and Victoria and our view remains that after an initial bounce the property upswing will be constrained by still tight lending standards, a large backlog of new units yet to hit the Sydney and Melbourne property markets, weak economic conditions and now poor consumer confidence. Dwelling commencements rose slightly in the June quarter but given the continuing decline in building approvals are set to resume falling for the rest of the year.
On balance, this is all consistent with the need for more policy stimulus ideally from fiscal easing but most likely in the near term from the RBA.
What to watch over the next week?
The big focus in the week ahead will no doubt be on the mini trade deal agreed in principle between the US and China.
In the US on the data front, expect a solid rise in September retail sales and continued strength in home buyer conditions (both due Wednesday), a slight pull back in housing starts (Thursday) but after a very strong gain in August and a small fall in industrial production (also due Thursday). Manufacturing conditions for the New York and Philadelphia regions will also be released. The September quarter earnings reporting season will kick off in the week ahead with consensus expectations for a roughly -3% year on year decline in earnings per share led by energy, materials and tech stocks with revenue growth of roughly 3%yoy.
Japanese core inflation for September (Friday) is expected to remain soft at around 0.6% year on year.
Chinese September quarter GDP growth (Friday) is expected to show a further slowing to 6.1% year on year (from 6.2% in the June qtr) as the trade war & the earlier credit tightening continue to impact. September activity data also due Friday is expected to show a rebound in growth in industrial production to 5%yoy and retail sales to 7.8% but flat growth in investment at 5.5%. Meanwhile, September trade data (Monday) is expected to show a slowing in exports to -3%yoy and continued weakness in imports around -6%yoy. CPI inflation (Tuesday) is expected to rise a bit further to 2.9%yoy as a result of swine flu but core inflation is likely to remain weak & producer price deflation is expected to intensify to -1.3%yoy. Money supply and credit data will also be released.
The minutes from the RBA’s last board meeting are expected to be dovish and repeat that the RBA will ease monetary policy again if needed to support growth, full employment and the inflation target. September jobs data to be released Thursday are expected to show jobs growth of 20,000 with unemployment remaining at 5.3% and underemployment remaining high consistent with further monetary easing ahead.
Outlook for investment markets
Share markets remain at risk of further volatility in the months ahead given issues around trade, Iran & the Middle East, impeachment noise and weak global economic data. But valuations are okay – particularly against low bond yields, global growth indicators are expected to improve by next year and monetary and fiscal policy are becoming more supportive all of which should support decent gains for share markets on a 6 to 12 month horizon.
Low yields are likely to see low returns from bonds once their yields bottom out, but government bonds remain excellent portfolio diversifiers.
Unlisted commercial property and infrastructure are likely to see reasonable returns. Although retail property is weak, lower for longer bond yields will help underpin unlisted asset valuations.
The election outcome, rate cuts, tax cuts and the removal of the 7% mortgage rate test are driving a rise in national average capital city home prices led by Sydney and Melbourne. But beyond an initial bounce, home price gains are likely to be constrained through next year as lending standards remain tight, the record supply of units continues to impact and rising unemployment acts as a constraint.
Cash and bank deposits are likely to provide poor returns as the RBA cuts the official cash rate to 0.25% by early next year.
The A$ is likely to fall further to around US$0.65 as the RBA cuts rates further. Excessive A$ short positions, still high iron ore prices and Fed easing will provide some support though with occasional bounces and will likely prevent an A$ crash.