10 March 2017
While US shares fell over the last week on nervousness ahead of a likely Fed rate hike, the loss was cut to 0.4% after the release of solid jobs data on Friday & most share markets rose with European shares up 0.3%, Japanese shares up 0.7%, Australian shares gaining 0.8% and Chinese shares flat. Bond yields pushed up in most regions – with yields in the US and Australia rising above their highs in December last year. Commodity prices were generally soft with the oil price down 9% as US oil stockpiles rose with shale oil production looking like its offsetting OPEC production cuts. While the US$ ended little changed, the A$ fell to US$0.7544.
Solid US employment growth of 235,000 in February, a fall in unemployment and a slight rise in wages growth keep the Fed on track to raise interest rates again this coming Wednesday. By the same token the pick-up in wages growth remains very gradual and a likely rise in labour force participation will help keep it that way, which in turn supports the view that future Fed rate hikes will be gradual too.
With short term investor sentiment towards shares remaining very bullish, nervousness around a third Fed rate hike (along with worries around President Trump, Eurozone elections or even North Korea) could help drive a correction in shares. However, with US monetary policy a long way from being tight, future rate hikes likely to be gradual and US economic data likely to be solid we don’t see it derailing the bull market in shares.
While I am not so worried about a Eurozone break up (support for the Dutch Freedom Party seems to be fading and Marine Le Pen may have peaked in France at levels that won’t result in a victory in the second round), North Korea is worth watching. Tensions have clearly escalated with North Korea’s latest missile test, South Korea employing the US THAAD missile defence system and China sanctioning both Koreas. This is likely to be just be another flare up in tensions to be followed by a cooling, but it’s a bit less certain than in the past given North Korea’s nuclear capability and the US looking at “all options”. At least two things have been cleared up: despite pre-election rhetoric to the contrary the US under President Trump is standing behind South Korea and Japan; and the upholding of President Park’s impeachment will see South Korea move forward on its political mess with new elections likely to see a new Democratic Party of Korea government take a less hard-line position towards North Korea.
RBA on hold at 1.5%, for the seventh month in a row. As noted last week 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 underlying inflation. That said, talk of a rate hike this year is way too premature. Just because the US is hiking does not mean that the RBA will follow suit. The US is further into a growth recovery cycle than Australia and since the Global Financial Crisis RBA interest rate moves have diverged from those in the US – with the RBA hiking in 2009 and 2010 when the Fed was on hold and the RBA cutting rates last year when the Fed had increased rates.
More macro-prudential measures to slow housing may be on the way in Australia? While I may be jumping at shadows, the latest post meeting Statement from the RBA implied a bit of unease regarding lending to residential property investors and lending standards, probably on the back of the continuing surge in Sydney and Melbourne home prices. Most notably in the February Statement it said that “supervisory measures have strengthened lending standards” whereas its now saying that “supervisory measures have contributed to some strengthening of lending standards” which suggests the RBA thinks a further tightening in lending standards in relation to lending for housing may be required. More macro-prudential measures to slow property investment may be on the way and this could take the form of lowering the threshold for growth in banks’ total lending to investors to say 7% year on year from 10% currently.
The past week saw the 100 year anniversary of the first Russian revolution (what a fizzer and waste of life the second one later the same year turned out to be!) and International Women’s Day. To help track the economic progress of Australian women, Financy (a women’s money website) and Data Digger (a data company) have produced an index that brings together six key indicators. What is interesting is that our biggest listed corporates are driving change at the very top with more women on boards and this is the main driver of the Financy Women’s Index since 2012. Hopefully the realisation of the benefits of gender diversity on boards will trickle down through our workforce in the years ahead.
Major global economic events and implication
US jobs data was strong with payrolls up solidly and continuing very low jobless claims and a strong rise in imports driving a deterioration in the US trade deficit.
As expected the ECB left monetary policy on hold with President Draghi expressing a bit more confidence in the growth outlook but yet to be convinced the rise in headline inflation is sustainable and still sounding dovish, albeit a bit less so. We can’t see the ECB announcing a tapering to its quantitative easing program for 2018 until after the French election is out of the way and assuming Marine Le Pen does not win.
Chinese macro-economic targets for 2017 from the People’s Congress contained few surprises – growth at 6.5%, inflation at 3% and the budget deficit as a percentage of GDP at 3% – and confirmed that the focus is on stability.
Chinese economic data was a bit mixed. While imports surged 38% year on year in February pointing to strong domestic demand, exports surprisingly fell 1% yoy which is contrary to evidence of stronger global growth. Both look a bit exaggerated and may be reflect distortions due to the timing of the Chinese New Year holiday. Similarly while producer price inflation accelerated further in February to 7.8% yoy, consumer price inflation fell suggesting little pass through of the rise in producer prices. Again holiday distortions may be playing a role. While it’s clear that deflation has ended, producer price inflation is likely to slow going forward as the low base in commodity prices drops out of the annual calculation. Finally credit growth slowed sharply in February. PBOC tightening may have played a role but the slowing largely reflects a reaction to the surge in January. Given the month to month volatility its best to take an average of the last two months and it remains solid. Chinese data is consistent with further modest PBOC tightening, but it’s likely to remain gradual.
Australian economic events and implications
Australian retail sales bounced back in January after a couple of soft months telling us that consumer spending has started 2017 on a solid note. While ANZ job ads fell in February this followed a strong January and the trend points to solid jobs growth going forward. Finally, housing finance was stronger than expected in January due to another surge in lending to property investors – which is up nearly 28% from a year ago highlighting that the dampening impact of APRA’s macro-prudential controls has worn off.
What to watch over the next week?
In the US, all eyes will be on the Fed which on Wednesday is expected to announce its third rate hike for this cycle increasing the Fed Funds rate by 0.25% to a range of 0.75-1%. We have seen a run of solid economic data, the Fed is at or close to meeting its inflation and employment objectives and such a move has been well flagged by Janet Yellen and others at the Fed. As such, the money market is attaching a 100% probability to a hike on Wednesday. The main focus though will be the Fed’s commentary around the move which is likely to indicate that future moves will be conditional on continued economic improvement and that they will likely remain gradual. The so-called dot plot of Fed officials’ interest rate expectations could also shift up from showing 3 rate hikes this year to 4. There may also be some discussion on when to start shrinking the Fed’s balance sheet but the message is likely to remain that this will wait until the Fed Funds rate is closer to “normal” and that it will be achieved by letting maturing assets run off.
On the data front in the US expect strength in small business optimism (Monday), a further rise in headline CPI inflation to 2.6% year on year but a slight fall in core inflation to 2.2% yoy, a modest rise in retail sales and continued strength in the NAHB home builders’ index (all Tuesday), a rise in housing starts (Thursday) and a rise in industrial production (Friday).
The main event in Europe will be the Dutch election on Wednesday. Recent polling points to a decline in support for the Gert Wilders’ Eurosceptic Freedom Party from around 20% of the vote to less than 16%. It won’t be able to form government which will ultimately come from a coalition of centrist parties (which have indicated that they will not work with Mr Wilders). An outcome around these levels would be a positive sign for the Eurozone continuing to stay together and hence a positive for Eurozone shares.
The Bank of Japan (Thursday) is not expected to make any changes to monetary policy having committed in September to open ended quantitative easing until it exceeds its 2% inflation target, which at this stage remains a long way away.
The BoE (Thursday) will probably make no changes to policy.
Chinese activity data for January/February (Tuesday) is expected to confirm that momentum in growth remained solid into 2017 with industrial production likely to pick up to 6.3% year on year (from 6% in December), retail sales likely to accelerate to 10.6% (from 10.4%) and fixed asset investment likely to accelerate to growth of 8.5% (from 8.1%).
In Australia, expect business conditions and confidence to remain at high levels according to the February NAB business survey (Tuesday), consumer confidence (Wednesday) to have risen slightly and February jobs data (Thursday) to show a 15,000 gain in employment and unemployment rising again to 5.8% on the back of higher participation.
Outlook for markets
Shares remain vulnerable to a short term pull back as investor sentiment towards them is very bullish, the Fed is getting a bit more aggressive, Trump-related uncertainty remains, various European elections could create some nervousness and North Korea is a potential risk factor as well. 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. They look to be starting their bear market again after a pause in the rise in yields since December.
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%.
For the past year the A$ has been range bound between US$0.72 and US$0.78 and this may continue for some time yet. At some point this year though, the downtrend in the A$ from 2011 is likely to resume as the interest rate differential in favour of Australia narrows (as the Fed hikes 3 or 4 times and the RBA remains on hold).