27 October 2017
Global share markets rose over last week, boosted by solid earnings and economic data. US shares rose 0.2% with strong gains in tech stocks, Eurozone shares gained 1.2% helped by a dovish European Central Bank (ECB), Japanese shares rose 2.6% as Abenomics continues following the Japanese election and Chinese shares gained 2.4%. Australian shares fell 0.1%, as the market was impacted by political uncertainty at the end of the week after the High Court’s citizenship decision. Bond yields rose in the US and UK but fell elsewhere. While iron ore prices declined, oil prices rose. The US$ had another leg higher on strong US data and ECB dovishness and this, along with lower than expected Australian inflation, saw the A$ fall below US 77 cents.
As widely expected, the ECB announced a further extension of its quantitative easing program at the reduced rate of €30 billion a month from January 2018 for nine months and “beyond, if necessary”, with ECB President Draghi saying it won’t suddenly stop next October. In doing so, the ECB reiterated that interest rates will not be raised until “well after” QE ends, which implies not until 2019 at the earliest. Continuing QE and low rates in the Eurozone is a big positive for Eurozone shares, and at a time when the US Federal Reserve (the Fed) is undertaking rate hikes and quantitative tightening points to downwards pressure on the Euro. The continuation of QE in Europe, when Japan remains locked on QE and zero 10-year bond yields and the US is only tightening gradually, highlights that global monetary conditions will remain easy for a long while yet. This, along with strong economic growth and earnings largely explains why global share markets are so strong.
The focus on Catalonia is ramping up again after its Parliament declared independence and the Spanish Government moved to take control of it ahead of a fresh regional election. Negotiations would seem a better way to proceed, but we remain of the view that it’s not a major European (let alone global) issue: the unilateral Catalan independence declaration has little meaning; although there will be protests and strikes, Catalans are unlikely to rise up en masse and resist a central government takeover; and the issue is not about the survival of the euro with Catalonia wishing to remain in it. Reflecting this, Spanish shares fell 1.5% on Friday whereas Eurozone shares rose.
China’s Communist Party Congress saw an enhanced authority for President Xi Jinping, as evident in the new seven-member leadership team, the absence of any heir appointed in the team and his “Thoughts on Socialism with Chinese Characteristics for a New Era” being enshrined in the Party’s constitution. However, we continue to expect a continuation of the recent direction in policy rather than a big shift in direction. That said, there will be more focus on sustainable growth – supply side economic reforms, rebalancing towards more consumption-driven growth and measures to deal with financial risks, pollution and inequality – and less focus on growth for growth’s sake. While there may be less emphasis on growth targets, the objective to double 2010 GDP by 2020 implies GDP growth of 6-6.5% per year. So expect growth to remain solid, even though there will be more focus on sustainability.
Is President Xi “recklessly building China on a foundation of sand” as a well-known US hedge fund manager suggested, presumably as a reference to rising debt? Not that I can see. Yes, debt levels have gone up rapidly but it borrows from itself, it hasn’t blown it on reckless consumption and it is aware of the problem. If anything, it saves too much and has the problem that a big chunk of that saving is recycled through its banking system (which means it gets called debt). Yes, it has problems with unequal development and pollution – but so have all rapidly developing economies. Is it fair to criticise China on the grounds that “true developed economies do not impose severe capital controls or move short-term interest rates hundreds of basis points overnight in attempts to manipulate their own currency” as the same hedge fund manager also said? Again, I don’t think so – China is still a developing economy and most developed economies (the US and Australia included) have had phases of heavy market regulation, often well after China’s current level of development.
Progress continues towards tax reform in the US, with the House passing the Senate’s 2018 budget which will allow tax reform to proceed under the so-called budget “reconciliation” process. Our assessment is that it now has a 70% chance of getting up by early next year. The biggest risk is that the package loses the support of more than two GOP senators (for ideological reasons, feuds with Trump, poor health or a loss to the Democrats in the Alabama special senate election). Trump’s fights with various Republican senators highlight this risk, although it must be remembered that tax cuts/reform are a fundamental Republican objective (that is, it’s much more than Trump) and Republicans need a big win on something like tax reform ahead of the 2018 mid-term Congressional elections. (It’s worth noting, though, that some Democrat senators may support tax reform – as they did in relation to the Bush-era tax cuts.) There is also uncertainty about the size of the fiscal stimulus tax reform will provide – for instance, will it rely on a growth dividend (called “dynamic scoring”) to make it revenue-neutral over time, or will the tax cuts expire after ten years similar to the Bush-era tax cuts? Out of interest, the Senate budget allows for a US$1.5 trillion net deficit increase due to tax reform over ten years, which if spread evenly is about 0.1% of GDP a year, but it is likely to be more front-loaded.
But at a big picture level, tax reform in the US will mean a small boost (maybe 0.2% to 0.3%) to 2018 GDP growth, a likely additional US Fed rate hike (four hikes in 2018 rather than three) and more upwards pressure on US bond yields and the US$. For Australia, US tax reform would mean a lower than otherwise A$, more flexibility for the RBA and more pressure to lower our corporate tax rate. Given the risk, some companies may choose to relocate their headquarters to the US.
In Australia, the High Court’s disqualification of four senators and the Deputy Prime Minister (PM) from sitting in parliament due to their dual citizenship has led to an increase in political uncertainty. The four senators will be replaced by people from their own party but the Deputy PM must face a December by-election, which if he loses will mean the Government will lose its majority. However, initial polling suggests he is likely to retain his seat and even if he doesn’t it’s unlikely that all four independent members will vote with the ALP and Greens. So the Government is likely to retain power but only just, which mitigates a risk should the Government face another by-election. The greater risk is that increased political uncertainty damages business confidence and adds to downward pressure on the A$.
And finally, it was a sad week for the Australian music scene with the death of George Young. Most Australians would know of Lennon and McCartney, or Bacharach and David, or maybe even Tennant and Lowe and I reckon the song-writing partnership of George Young and Harry Vanda that started with The Easybeats and ran through songs for John-Paul Young, Ted Mulry and others is Australia’s answer to them. Anyway “do yourself a favour” and check George Young out here.
Major global economic events and implications
US data remains strong with strong business conditions’ PMIs, a rebound in new home sales, solid gains in durable goods orders pointing to solid business investment and ultra-low jobless claims. While GDP growth came in at 3% annualised in the September quarter, private demand growth slowed, partly due to the hurricanes, however looks likely to bounce back strongly in the current quarter. September quarter earnings reports have continued to surprise on the upside, with 79% beating on earnings and 68% beating on sales.
Eurozone business conditions’ PMIs remain strong (up for manufacturers and down for services) and the German Ifo Business Climate Survey has almost reached its highest level since 1969.
Japanese core inflation remained at 0.2% year-on-year in the September quarter which is well below the Bank of Japan’s 2% target, ensuring its ultra-easy monetary policy will continue.
Chinese home prices were flat in September under the influence of property cooling measures, but industrial profits surged 27.7% which is consistent with strong growth.
Australian economic events and implications
Australian inflation surprised again on the downside in the September quarter, producer prices were weak and import prices fell – Reserve Bank of Australia (RBA) rate hikes are still a way off. Our view remains that the RBA won’t raise interest rates until late next year, as it will take a while for a gradual pick-up in economic growth to flow through to wages growth and higher underlying inflation. RBA Deputy Governor Debelle’s reference to sizeable spare capacity in the labour market and flat Phillips curves implies ongoing RBA concern about low wages growth.
What to watch over the next week?
In the US, the Fed (Wednesday) is expected to leave interest rates on hold but indicate that recent weakness in inflation is likely to be temporary, given strong indications regarding growth. Hence, the Fed remains on track to raise interest rates again in December and quantitative tightening is proceeding as planned. On the data front, the main focus will be on October jobs data (Friday), which is expected to show a 300,000 rebound in payrolls to make up for the hurricane-driven 33,000 decline seen in September. Unemployment is expected to remain around 4.2%, although wages growth may also slip back a bit to 2.7% year-on-year. Meanwhile, expect to see strong growth in personal spending but continued low core inflation for September (Monday), ongoing gains in home prices, solid consumer confidence and an edging up in employment costs (all Tuesday), continued strength in the ISM manufacturing index (Wednesday) and a slight worsening in the trade deficit (Friday). September quarter earnings results will also continue to be announced.
President Trump will likely also announce his nomination for Fed Chair – it seems to have come down to a choice between existing Chair Yellen, current Fed Governor Jerome Powell and academic John Taylor. Yellen and Powell would be more of the same and Taylor may be seen as a bit more hawkish, albeit he has said that his Taylor rule should not be applied mechanically. However, it’s doubtful the choice will change the tightening path the Fed takes over the next year, while Taylor may be slower to respond in the event of a deflationary crisis.
Eurozone data is expected to show continued strong readings for economic confidence (Monday), a fall in unemployment to 9%, a rise in September quarter GDP growth of 0.6% quarter-on-quarter (or 2.5% year-on-year) and underlying inflation (all Tuesday) remaining at 1.1% year-on-year.
Japanese data is expected to show continued labour market strength, a pick-up in household spending growth and some slowing in industrial production (Tuesday). However, reflecting ongoing near-zero core inflation the Bank of Japan, which also meets on Tuesday, is expected to continue quantitative easing and keep the 10-year bond yield around zero.
China’s manufacturing conditions PMIs (Tuesday and Wednesday) are expected to point to continued solid growth.
In Australia, we expect continued moderate growth in credit (Tuesday), CoreLogic data (Wednesday) to show further evidence of a moderation in home price growth, a 1% fall in building approvals (Thursday) and a 0.3% gain in September retail sales (Friday) after two months of falls. September quarter real retail sales data is expected to show a sharp slowing.
Outlook for markets
US shares are overdue a correction, but looking beyond short term uncertainties we remain in a sweet spot in the investment cycle – with okay valuations particularly outside of the US, solid global growth and improving profits but still benign monetary conditions – so we remain of the view that the broad trend in share markets will remain up. Australian shares are likely to continue to participate in the global share rally, but remain a relative laggard thanks to a more constrained earnings outlook.
Bond yields look to be starting to break higher again, led by US bonds. Low starting point bond yields and a likely rising trend in yields will likely drive poor returns from bonds.
Unlisted commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this will wane eventually as bond yields trend higher.
Residential property price growth in Sydney and Melbourne looks to have peaked with a slowdown likely over the next year or two, but Perth and Darwin are likely close to the bottom, Hobart is likely to remain strong and moderate price gains are expected to continue in Adelaide and Brisbane.
Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.25%.
With the RBA on hold for the next year or so and the Fed on track to hike in December with another three or four hikes next year the interest rate differential will continue to move against Australia, which should result in further weakness in the A$.