28 April 2017
The past week saw ‘risk on’ following the outcome of the first round of the French election and in anticipation of President Trump’s tax plan. Mostly good economic and earnings news helped too. This saw US shares up 1.5%, Eurozone shares up 3.4%, Japanese shares rise 3.1% and Australian shares gain 1.8%, but Chinese shares dipped 0.8% on news of tighter financial regulation. Reflecting the risk-on tone, bond yields rose in core countries (but fell sharply in France), but commodity prices were mixed and the A$ fell.
There has been a lot of action on the policy front in the US over the last week – most of which has been positive:
- President Trump’s much anticipated tax plan provided few surprises: a reduction in the corporate tax rate to 15% (from 35%); a one off tax on repatriated cash earnings (of 10%); no border adjustment tax (it’s just too hard); collapsing the personal tax brackets from seven to just three of 12%, 25% and 33% (with the current top bracket being 39.6%); doubling the tax-free threshold to $US24,000; and cutting itemised deductions. While it was short on details this is to be expected as it is really just an opening statement of principles with agreement to be reached with Republicans in Congress who have their own plans that head in the same direction, ie lower rates. So compromise is likely – probably resulting in a corporate tax rate of 20% rather than 15%. If the package is “revenue neutral” after 10 years – helped by savings from Obamacare reform, less deductions and “dynamic scoring” which takes account of a possible growth dividend then it should pass Congress with just a simple majority in the Senate (which the Republicans have). But if it’s not revenue neutral, 8 Democrat senators will be needed to support it and that’s a big ask – so expect it to be “revenue neutral”, although that still means a boost to growth. There is a long way to go yet so tax reform may not make it into law until early next year. But what the plan shows is that tax reform remains high on the President’s agenda and this is all that matters for markets.
- Trade got back in headlines over the last week with the US imposing countervailing tariffs on Canadian softwood, investigating imports in relation to the steel and aluminium industries and talk of withdrawing from NAFTA. However, tariffs were deployed under Bush and Obama at times and Trump denied a withdrawal from NAFTA in favour of renegotiation. All of which sounds like bargaining noise. But we remain a long way from the trade war many fear.
- A US Government shutdown looks unlikely – with Congress agreeing on funding for a week and close to reaching a longer term funding agreement.
- Of course risks remain high around North Korea as it test fired another missile (which looks to have failed), although Trump indicated he prefers a diplomatic solution.
The first round of the French election saw a good result for markets (and France) with the centrist Macron wining 24% of the vote and the far right anti Euro Le Pen on 21.3% to now face each other in the run-off election on May 7. Macron’s relatively complacent post-election speech and team dinner in an up market restaurant did not get his round two campaign off to a strong start with Le Pen’s side playing up his establishment credentials. A portion of those who voted for centre right Fillon and far left Melenchon may also transfer their support to Le Pen and some 20-30% of voters may abstain. More terrorist attacks may also boost support for Le Pen. So a Le Pen victory is still possible. If this were to occur French citizens and investors would fear she will find a way out of the Euro even though there are immense barriers to such a move and this would likely see runs on French banks (remember Greece in 2015), a surge in French bond yields relative to German yields and a renewed bout of Eurozone break up fears weighing particularly on the Euro and Eurozone shares but also on global shares as was the case at the height of the Eurozone crisis in 2011-13. However, against this Macron has a solid poll lead of around 20% against Le Pen which is far wider than the 4% poll error seen in the Brexit vote and the 2% poll error seen in the US election. This is narrowing a bit – which may be a good thing in order to stop complacency sinking in – but our base case is that with the majority of the French wanting to stay in the Euro and negative towards the far right National Front that Le Pen represents Macron will ultimately win on May 7. Expect some nervousness along the way though.
Major global economic events and implications
US data was mostly good with a gradual rising trend in capital goods spending orders, solid home sales, continuing gains in home prices and still high consumer confidence. Meanwhile, March quarter profits continue to surprise on the upside. We have now seen 58% of companies report with 81% beating on earnings and 65% beating on sales. Earnings are up 12% year on year and on track for the fourth quarterly gain to new record highs. While March quarter GDP growth slowed to just 0.7% annualised this appears to reflect a seasonal distortion that will reverse in the June quarter. Over the last 20 years March quarter growth has been about 1% weaker than the other quarters and has been followed by a June quarter rebound. Solid business conditions readings, strong profit growth and ultra low jobless claims also indicate underlying growth is much stronger and the 1% March quarter growth detraction from inventories won’t be repeated.
As expected the ECB made no changes to monetary policy with President Draghi more upbeat on growth but remaining relatively dovish on the back of weak core inflation. Meanwhile April confidence readings in the Eurozone pushed up to the highest levels since before the GFC. While inflation bounced in April this was largely due to a seasonal distortion due to Easter.
The Bank of Japan also remained on hold consistent with its commitment to continue quantitative easing and zero bond yields until inflation exceeds 2%. Given core inflation fell to -0.1% yoy in March this will be the case for a long time.
Australian economic events and implications
In Australia, headline inflation rose to 2.1% yoy in the March quarter putting it back in the RBA’s 2-3% target range. This is good news to the extent it signals that the risk of deflation has receded. But it’s too early to get excited. The cost of living is now rising faster than wages and this will act as a drag on household spending. And abstracting from higher petrol prices and increases in prices for government influenced items like utilities, health and education underlying inflation in the market sector of the economy remains too low at just 1% yoy.
In other data, producer price inflation remains soft, skilled vacancies fell for the second month in a row which is a bit of a concern, credit growth remained weak with lending to property investors slowing but a surge in export prices in the March quarter points to another rise in Australia’s terms of trade.
Meanwhile, with the Federal Budget close two things are worth highlighting. First, the Government is playing down what it can deliver on housing affordability – maybe a few fiddles to encourage downsizing but since the big issue is supply and that is a state issue there is not really much it can do. Second, its new found focus on distinguishing between “good” debt (where debt is used to finance investment in assets like infrastructure that have a long term payoff) and “bad” debt (where debt is used to finance current spending) makes some sense. There is logic in using debt mainly for assets as it spreads the cost of paying for them to future generations who will benefit from them and such an approach may help reinvigorate the focus on getting current spending under control. The danger though is that it just results in a smoke and mirrors trick that allows a further ramp up in debt with no real slowing in recurrent spending. Ratings agencies would just see through that and such an approach did not help the WA Government. That said, it does look like there will be a ramp up in debt financed infrastructure spending in the coming budget.
What to watch over the next week?
In the US, the Fed (Wednesday) is expected to make no changes to monetary policy but signal ongoing confidence in the US outlook and that a gradual normalisation of monetary policy remains appropriate consistent with another rate hike in June and a start to letting its balance sheet decline later this year. Meanwhile, expect the April ISM business conditions indexes (Monday & Wednesday) to remain strong at around 56, the core consumption deflator for March (Monday) to fall to 1.6% yoy and March employment growth to bounce back to a solid 195,000 but wages growth to remain at 2.7% year on year. US March quarter earnings will continue to flow.
In the Eurozone expect unemployment (Tuesday) for March to fall to 9.4% from 9.5% and March quarter GDP growth (Wednesday) is expected to rise 0.6% qoq or 1.8% yoy.
China’s Caixin manufacturing conditions PMI (Tuesday) is expected to rise slightly to 51.4.
In Australia, the Reserve Bank (Tuesday) is expected to leave the cash rate on hold at 1.5% for the ninth month in a row. The rise in headline inflation to back within the RBA’s 2-3% target zone has reduced the pressure to cut rates again at a time when the RBA would rather not cut any way given worries about the Sydney and Melbourne property markets, but continuing low underlying inflation pressure at a time of very high underemployment, record low wages growth and a still too high A$ means that its way too early to be thinking about raising rates. Our base case remains that the RBA will be on hold out to the second half of 2018 when rates will start to rise. The RBA’s quarterly Statement on Monetary Policy (Friday) is unlikely to make any significant changes to its forecasts. On the data front, expect CoreLogic data (Monday) to show a stalling in home price growth in April possibly reflecting softer investor demand on the back of higher bank rates, tighter lending standards and all the bubble talk. The March trade surplus (Thursday) is likely to have fallen.
Outlook for markets
Shares remain vulnerable to short term setbacks particularly given the risks around North Korea and the final round of the French election. But 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. A resumption of the bond bear market looks to be getting underway and this is likely to see a gradual rise in yields.
Unlisted 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.
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 US$0.72 and US$0.78, but at some point this year the downtrend in the A$ 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 February highs.