03 March 2017
The past week saw US shares rise 0.7%, European shares gain 2.6% and Japanese shares rise 1% helped by strong US forward looking data, signs that the US Federal Reserve is increasingly confident in the US outlook and confidence that President Trump is in on track with his pro-business agenda. By contrast Australian shares fell 0.2% and Chinese shares fell 1.3%. Bond yields generally rose as the probability of a March US rate hike rose and this also saw the US dollar rise slightly which in turn put downwards pressure on some commodity prices and the Australian dollar, notwithstanding a reversal on Friday.
Despite much anticipation, President Trump’s Congressional address provided little detail on his pro-business policies but he made plenty of references to deregulation, corporate and personal tax cuts and infrastructure spending and he sounded more presidential. As a result share markets remained happy. Interestingly the Trump Administration also sent to Congress its trade policy agenda which made reference to pursuing bilateral trade deals and renegotiating existing deals but does not signal the widespread application of tariffs, which adds confidence to the view that a trade war will be avoided.
There was more interest in relation to the US Federal Reserve, where comments by various officials that it should move “soon” to raise rates again and that the risks were “starting to tilt to the upside” backed up by Chair Yellen and Vice Chair Fischer saw the money market’s implied probability of a March rate hike rise to 94%. Given the run of strong US data and with Yellen, Fischer and New York Federal Reserve President Dudley confirming that a March hike is likely, we have moved our timing for the next US rate hike from May/June to March. If this were happening a year ago share markets would have gone into a tailspin. But because the US economy is stronger now, the US Federal Reserve’s confidence in the outlook actually seems to be supporting the share market. After the strong gains since the US election, the likelihood of a short term share market correction remains high. That said the US share market seems to be following the pattern seen in previous rate hiking cycles, i.e. a pullback around the first hike (February 1994, June 2004 and December 2015) and then rallying into and through subsequent hikes because economic data is better. Back in the 2004-2006 tightening cycle rates were going up at every US Federal Reserve meeting and it took 17 hikes to ultimately kill the bull market off. A March hike would potentially open the door to four hikes this year, but compared to the 2004-2006 rate hike cycle, this time around the tightening process is likely to be a lot slower reflecting still constrained Gross Domestic Product growth (so far March quarter growth looks like being below 2% again), still low wages growth and the strong and rising US dollar. Consistent with this Janet Yellen indicated that she sees no evidence the US Federal Reserve is behind the curve and continues to see rate hikes as being “gradual”, albeit faster than in the last two years.
Source: Bloomberg, AMP Capital
The Organisation for Economic Co-operation and Development is right to warn about Australian house prices, excessive household debt and the risk to the economy. Such risks are real, particularly with Sydney home prices up 73% over the last five years against wages growth of just 13%. Housing – both affordability and the nexus of excessive home price and household debt growth – remains Australia’s Achilles heel. It’s worth noting though that such warnings have been issued continuously since 2003 and yet the property market keeps on keeping on. Our view remains that unit prices in some oversupplied areas will fall 15-20% at some point and that a 5-10% cyclical downturn in average home prices is likely once interest rates start to rise. But it remains hard to see a generalised home price crash in the absence of: much higher interest rates causing a wave of defaults (but the Reserve Bank of Australia is not going to raise interest rates until it gets to that point); a surge in unemployment (of which there is no sign at present); and a continuing surge in supply (but building approvals look to have peaked). While the property market is proving even stronger than I thought, my views on the risk of a property crash are unchanged from those in this note.
Major global economic events and implication
US data was mixed – but where it counts in the forward looking indicators it was strong. On the soft side December quarter Gross Domestic Product growth was left unchanged at 1.9%, pending home sales fell, construction fell, real consumer spending fell in January and the trade deficit widened. But more importantly, consumer confidence rose to its highest since 2001, unemployment claims fell to their lowest since March 1973 and the Institute for Supply Management conditions indexes rose to strong levels near 58.
In the Eurozone economic confidence rose to a new six year high adding to the message from business conditions Purchasing Managers’ Index data that growth is likely to accelerate. Meanwhile headline inflation rose to 2% year-on-year in February on higher energy prices, but core inflation remained stuck at 0.9%.
Japanese industrial production fell in January but the manufacturing conditions Purchasing Managers’ Index data points to a rebound going forward. Labour market data was strong, but household spending was weak and core inflation remained low at 0.2% year-on-year. The Bank of Japan remains a long way away from tightening.
Chinese manufacturing Purchasing Managers’ Index data improved in February and services conditions held strong consistent with solid growth.
Rising export momentum across Asia – with Korean exports up 20% year-on-year – is consistent with the stronger global growth theme. Even Indian Gross Domestic Product growth surprised on the upside in the December quarter, despite “demonetisation”.
Australian economic events and implications
The Australian economy saw some good news with December quarter real Gross Domestic Product rebounding by a greater than expected 1.1% quarter on quarter, robbing the doomsters from being able to declare a recession. The rebound in real growth was broad based across consumer spending, public demand, housing investment, business investment and trade. Nominal growth was also strong reflecting higher commodity prices, which in particular supported profits. While growth will likely slow back a touch in the current quarter on slower consumer spending and trade, it’s likely to be close to 3% throughout 2017. In other data, the trade surplus fell sharply in January but this looks to be largely due to temporary factors including the early timing of the Chinese New Year holiday and a slump in volatile gold exports. Building approvals rose slightly in January and new home sales fell slightly but the trend is down in both pointing to a loss of momentum in housing investment. House price growth though stayed uncomfortably strong in Sydney and Melbourne in February according to CoreLogic adding to Reserve Bank of Australia wariness about cutting rates again.
The Australian December half-year profit reporting season wrapped up and left listed company profits on track for a 19% rise this financial year after two consecutive years of falls. The profit turnaround has all been driven by resources companies which are on track for a rise in profit of 150% this financial year reflecting the benefits of higher commodity prices and volumes on a tighter cost base. Profit growth across the rest of the market is likely to be around 5% but it should accelerate in 2017-18 as economic growth improves.
What to watch over the next week?
In the US, February jobs data on Friday will be watched very closely as it’s the last major data release ahead of the US Federal Reserve’s 15 March meeting. Payrolls are expected to rise by around 190,000 with unemployment falling back to 4.7% and wages growth edging up. Coming on the back of a run of solid data releases this should keep the central bank on track for a rate hike on March 15. Meanwhile, expect the January trade deficit (Tuesday) to worsen slightly.
The European Central Bank is expected to make no change to monetary policy on Thursday. It has already committed to continue its €60 billion per month asset buying program to year-end and it’s premature to expect any announcement regarding a 2018 taper, particularly with risks around the French election and core inflation remaining well below target at 0.9% year-on-year.
Chinese import and export growth for February (Wednesday) is likely to show a further acceleration with imports up 18% year-on-year and exports up 14% year-on-year and while Consumer Price Inflation (Thursday) is likely to drop back to 2% year-on-year, Producer Price Inflation is expected to accelerate further to 7.5% year-on-year. The National People’s Congress that starts on Sunday is likely to confirm a growth target of around 6.5% this year.
The Reserve Bank of Australia is expected to leave interest rates on hold when it meets Tuesday. Economic growth bounced back nicely in the December quarter, recent economic data has been reasonable – particularly business conditions surveys, national income is rising again and growth in Sydney and Melbourne property prices is too strong for comfort. As a result we expect the Reserve Bank of Australia to leave the official cash rate at 1.5% and we now expect it 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 inflation to convince it to cut again. On the data front expect January retail sales (Monday) to bounce back by 0.4% after a slight fall, but housing finance (Friday) to fall by 1.5%.
Outlook for markets
Shares remain vulnerable to a pull back as short term investor sentiment towards them is currently very bullish, the US Federal Reserve is getting a bit more aggressive, President Trump related uncertainty remains and various European elections could create nervousness in coming months. However, we see share markets trending higher over the next 12 months helped by ok 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. Australian bonds are preferred to global bonds reflecting higher yields and the fact that the Reserve Bank of Australia is well behind the US Federal Reserve in raising rates.
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%.
The Australian dollar could still see a retest of US$0.78 which if broken would likely see a run up to US$0.80. However, the downtrend in the Australian dollar from 2011 is likely to resume at some point this year as the interest rate differential in favour of Australia narrows (as the US hikes three or four times and the Reserve Bank of Australia remains on hold).