14 April 2017
Investment markets were in “risk off” mode over the last week in response to concerns about North Korea, Syria and the approaching French election. As a result, Australian shares gave up most of their gains from earlier in the week to end 0.5% higher, but US and Eurozone shares lost 1.1%, Japanese shares fell 2.1% and Chinese shares lost 0.9%. Safe havens like gold, government bonds and the Yen rallied. Apart from safe haven demand, bond yields were also pushed lower as President Trump indicated that he likes low interest rates. His comments that the US dollar was “too strong” also helped push the US$ lower which, despite a plunging iron ore price, saw the A$ move up. Oil strengthened.
Geopolitics dominated over the past week, with the ramifications of the US’ missile strike on Syria still reverberating and tensions around North Korea steadily building. The issues around Syria are likely to settle down assuming US involvement does not escalate, but North Korea is more risky. US naval ships have moved into the area, President Trump has indicated that the US will solve the North Korean problem with or without China and North Korea has threatened nuclear retaliation. Military conflict with North Korea would be risky given its ability to lob missiles into South Korea and Japan, potentially with nuclear warheads. Though in thinking about the risks around North Korea, it’s useful to think in terms of three scenarios as to how it could unfold:
At this stage it’s too early to prognosticate with confidence how it will turn out, but it’s hard to see the US committing ground forces, so it would no doubt be aiming at just a brief conflict at worst. In terms of the impact of wars on share markets, a naive view would suggest they are universally bad, but history tells us that this is not necessarily the case. The US share market rose by 15.7% pa through World War Two (from Pearl Harbour in 1941) and by 8.6% pa through the 1950-53 Korean conflict. While it only rose 0.6% pa though the Vietnam War, this reflected high and rising inflation. Shares have tended to sell off initially on the uncertainty of war with safe havens benefiting, but rally once the shooting starts and confidence builds the US will prevail. This was apparent In World War Two and in relation to the two Gulf Wars.
Of course each conflict is different, with a critical aspect in this case being the risk of North Korea using nuclear weapons. After the share market gains of the last year global and Australian shares are a bit vulnerable to a correction and military conflict with North Korea may be a trigger (whereas going into the gulf wars shares were actually quite cheap). The bottom line though is that while conflict with North Korea will likely cause some volatility in investment markets, a long drawn out negative impact is unlikely.
Nervousness is also building around the upcoming French presidential election with the first round on Sunday April 23rd. Polls for the first round show centrist pro-Euro Macron and far right anti-Euro Le Pen leading the race on around 23% of the vote each. However, they have dropped a point or two as far left candidate Melenchon has been catching up to centre right Fillon and overtaking him to be on around 18% of the vote. This has added to uncertainty around the election. If Macron and Le Pen make it through to the second round the odds of a Le Pen victory will be low as polls show Macron leading Le Pen by around 20%. Risks would remain – eg a terrorist attack boosting support for Le Pen – but the chance of a Le Pen victory would be low and markets could stop worrying about France destabilising the Eurozone. However, if Melenchon edges out Macron in the first round and goes into the second round facing Le Pen the prospect of either a far left or far right victory would be taken badly by markets as both would threaten the Euro and both advocate policies that would be negative for the French economy. Similarly, Fillon making it through to the second round in a contest with Le Pen would also be a concern given that Fillon is now a weakened candidate. Worries about France and Eurozone break up risks may escalate in the week ahead, although ultimately I still see a Macron victory.
Policy uncertainties also continue in the US, with President Trump indicating that his priority is to resolve reforming Obamacare before tax reform. If successful, this will free up budget funding for tax reform but it will likely also delay the tax reforms till late this year or early next. That said, Trump remains determined to pursue tax reform, which provides some comfort. President Trump also indicated that he likes low interest rates and Fed Chair Janet Yellen reversing expectations that he would stack the Fed with hawks. He also said the US$ was too strong – which is not surprising given most countries want a lower currency – but that he is not going to label China a currency manipulator, further easing fears of a trade war with China. President Trumps “reversals” on Russia, Syria, the Fed and China clearly indicate that Trump the Pragmatist is dominating Trump the Populist. He is becoming mainstream!
While Trump’s comments on the US$ being “too strong” have caused consternation, three things are worth noting. First, it’s not surprising – most countries want a lower currency. Second, a somewhat less strong US$ would actually be good for US company earnings and hence the share market and for the emerging world. Finally, regardless of this and what Trump says, the US$ will be driven by fundamentals – and relative monetary policies still point to an upwards bias for the US$.
Major global economic events and implications
US data was mixed. Small business optimism remains very strong, jobless claims remain ultra low and job openings, hiring and quits all remain strong. Against this, March retail sales were soft, adding to evidence that March quarter GDP growth will be weak and March CPI inflation was also weak with core inflation falling back to 2% year on year. March quarter GDP growth has a habit of being weak only to see growth rebound again, but all of this keeps the Fed on a gradual rate hiking path.
Chinese inflation data showed continuing low consumer price inflation and a slight easing in producer price inflation, which looks like it has peaked. Meanwhile, trade data showed a pick-up in exports and still strong imports and credit growth was stronger than expected.
Australian economic events and implications
In Australia, the RBA’s Financial Stability Review repeated its concerns around household debt, home prices, rising investor activity in Sydney and Melbourne and new unit supply. However, it noted that household financial stress is currently contained helped by low rates and that banks are well placed to manage the challenges. The Bank also seems confident that recently announced macro prudential controls will help contain the risks and that further measures will be considered if necessary. We remain of the view that bank rate hikes, tighter lending conditions, Federal Government measures in the May budget and rising unit supply will lead to a slowing in the Sydney and Melbourne property markets.
On the data front, March job growth surprised on the upside, driven by a big gain in full time jobs. While the jobs data is notoriously volatile month to month and the unchanged unemployment rate at 5.9% suggests caution in getting too excited, it seems that jobs growth is picking up a bit in Australia and this is consistent with leading labour market indicators. Meanwhile, the divergence between business confidence and conditions – which ranges from good to very good – and consumer confidence – which is a bit below average – remains. Quite clearly, weak wages and high levels of underemployment are continuing to weigh on households, which is a key argument against the RBA considering rate hikes at present.
What to watch over the next week?
In the US, of most interest will be the Markit business conditions PMIs for March (Friday) which are expected to remain solid at around 53. Housing data is likely to remain strong with the NAHB’s home builders’ conditions index (Monday) staying robust at around 70, housing starts (Tuesday) falling back slightly but after a strong gain in February, and rebounds in building approvals (also Tuesday) and existing home sales (Friday). Expect a rise in industrial production (Tuesday) and the Fed’s Beige Book (Wednesday) of anecdotal evidence to point to continued reasonable growth. March quarter earnings reports will also start to flow in earnest.
The first round of the French presidential election (Sunday April 23rd) will no doubt be the focus of attention in Europe. On the data front, expect Eurozone business conditions PMIs for April (Friday) to remain strong at around 56.
Chinese March quarter GDP growth (Monday) is expected to show growth to be unchanged at a solid 6.8% year on year, with March data for industrial production picking up to 6.2% year on year, but retail sales slowing to 10% and fixed asset investment running at around 8.9%.
In Australia, the minutes from the RBA’s last board meeting are likely to confirm a neutral stance on interest rates.
Outlook for markets
Shares remain vulnerable to a further short term pull back, as a lot of good news has been factored in, which has left them vulnerable to any bad news. Tensions around North Korea are a potential trigger. However, putting short term uncertainties aside, with valuations remaining okay, global monetary conditions remaining easy and profits improving on the back of stronger global growth, we continue to see any pullback in shares as an opportunity to “buy the dips”. Shares are likely to trend higher on a 6-12 month horizon.
Low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds. At present, bond yields are still consolidating after last year’s rise, but a resumption of the bear market is likely at some point in the months ahead seeing a gradual rise in yields.
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, as the heat comes out of Sydney and Melbourne.
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 $US0.72 and $US0.78 and this may continue for some time. At some point this year though, the downtrend in the A$ from 2011 is likely to resume as the interest rate differential in favour of Australia narrows (as the Fed hikes rates and the RBA holds), as the Fed eventually moves to reduce its balance sheet and hence narrow measures of US money supply and as the iron ore price remains down from its recent highs.