15 December 2017
Investment markets and key developments over the past week
Despite a continuing run of very favourable global economic news – highlighting strong growth, low inflation and benign central banks – share markets were mixed over the last week. US shares staged a late surge to be up 0.9%, helped by increasing signs tax reform will soon pass Congress, but Eurozone shares fell 0.9%, Japanese shares fell 1.1%, Chinese shares fell 0.6% and Australian shares were flat. Bond yields fell slightly in the US, on a dovish interpretation of the US Federal Reserve (the Fed) and fell in the UK on Brexit mayhem, but were flat in Germany, Japan and Australia. Oil prices were flat but copper and iron ore rose. The US$ was flat while strong jobs data saw the A$ rise.
US tax remains the big focus, with the loss of the Alabama special Senate election to the Democrats highlighting the political pressure on the Republicans to get it done. While it’s dangerous to read too much into the Alabama loss (given the issues around the Republican candidate), the result highlights a popular swing against the Republicans and the high risk that they will lose control of the House and the Senate in the mid-term elections. In the short term it adds to the urgency to get tax reform passed this year when the GOP still has 52 senators before the new senator takes his seat (likely early next year). However the GOP has long known this risk and this explains why they have been trying to get it done quickly.
And so far, so good with GOP House and Senate leaders already releasing their combined tax plan and a vote in the week ahead and key holdout senators (notably Corker and Rubio) saying they will vote “yes”. As expected, the key elements of the combined plan involve repealing the corporate alternative minimum tax, starting the corporate tax cut in 2018 (rather the 2019 as in the Senate bill) and expanding the state and local tax deduction to include income tax but raising the corporate tax rate to 21% (from 20%) to help “pay for” it.
Markets are underestimating the boost from tax reform. Many Americans seem to think they will see a tax hike as a result of the package, whereas in reality less than 7% of taxpayers will see a hike and most will see a cut with the bulk of the tax cuts going to households. A typical family at the median income are estimated to receive a $2,059 tax cut. Therefore, many households will get a positive surprise and this may provide a decent boost to consumer spending next year. Instant write-off of new business investment will likely also provide a boost to business investment. In total ,the stimulus is likely to be worth up to 1% of US gross domestic product in 2018. While there will be some slippage (tax cuts are always partly saved), the boost to US GDP could be significant at around 0.4%. So bond yields and the US dollar are likely to back up next year as the stimulus feeds through.
Another benign hike from the US Fed but the US futures market looks a bit too complacent regarding the Fed for next year. The fifth Fed hike in this tightening cycle was no surprise to anyone and with the Fed adjusting its growth forecasts upwards but not its inflation forecasts or dot plot projections for three hikes next year, it was taken as dovish, particularly with two dissents. So the futures market continues to expect just two hikes next year and bond yields fell. For now, we are still in the sweet spot – of good economic growth, good profit growth, low inflation and a benign Fed. However the market reaction was a bit too dovish – our view is that the risks on US inflation are starting to shift to the upside, with the very tight US labour market and rising producer price inflation. Don’t get me wrong, we are a long way from US monetary policy being tight and threatening US and global growth. However there is a rising risk that markets will be surprised by the Fed next year – we expect four hikes compared to market expectations for just two – and this (along with US tax cuts) is likely to see a resumption of the rising trend in bond yields, a higher US$, more share market volatility and the US share market underperforming other global markets (where central banks are more dovish).
Major global economic events and implications
‘Same-old same-old’ in the US with good activity readings but weak core inflation. Small business confidence surged to near its 1983 all-time high, retail sales remain very strong, the December Markit business conditions PMIs remain solid (albeit less so than the ISM indicators), industrial production rose with upwards revisions to October, jobless claims are still falling and readings for job openings, hiring and quits remain very strong. In fact, the level of job openings is now around the level of people unemployed, highlighting just how tight the US labour market is. Against this, core CPI inflation surprised on the downside yet again, with a fall back to 1.7% year-on-year from 1.8%. However, rising producer price inflation and the very tight labour market highlights the upside risks to US inflation.
The European Central Bank indicated more confidence in the growth outlook,but is still waiting for “a sustained upward trend” in inflation. Our view remains that a rate hike from the ECB won’t happen until 2019, after quantitative easing ends late in 2018. So the ECB is likely to remain supportive for Eurozone shares and negative for the euro for some time to come.
Japan looks to be jumping on the corporate tax-cutting bandwagon with a plan to cut its corporate tax rate from 30% to 20%. However there’s a catch – it will only apply to companies who boost wages by 3% and investment. Not a bad idea – if they can get it to work. The December Tankan and Nikkei PMI both showed a further rise in already strong business conditions.
Chinese activity data was a bit mixed with a slight slowing in industrial production but an uptick in retail sales growth and fixed asset investment, with the latter helped by property and infrastructure-related investment. While growth looks to have slowed a bit in the current quarter, the slowdown looks marginal. Meanwhile, following the US Fed’s latest hike the People’s Bank of China moved to raise short-term interest rates, but only by 5 basis points.
Australian economic events and implications
Australian economic data continues to support the ‘glass half full’ outlook for Australia. Firstly, very strong employment growth in November led by full-timers and the strongest pace of annual jobs growth since 2008 and falling underemployment is consistent with business remaining upbeat, and will provide a source of support for household income. Eventually this should show up in stronger wages growth, but the US experience and still high levels of labour market underutilisation suggests that this may take a while. Secondly, consumer confidence had a good bounce and may be catching up to business confidence. Finally, continuing very strong population growth (of 1.6% over the year to June) driven by immigration provides a strong source of demand growth, particularly for housing (notably in Victoria where the population is up 2.3% year-on-year) and will help limit the downside in home prices which ABS data confirmed are falling in Sydney and slowing in Melbourne.
Australians still see paying down debt and bank deposits as the wisest place for savings, property sentiment remains down from 2 years ago and shares are still viewed sceptically. A good sign for shares from a contrarian perspective.
Source: Westpac/MI, AMP Capital
What to watch over the next week?
In the US, the main focus will be on whether Congress passes the tax reform package (with the House likely to vote Tuesday and the Senate Wednesday) and whether a longer spending package will be agreed to head off a partial government shutdown on December 23. We remain of the view that both will be achieved. On the shutdown risk, while the negotiation is being ramped up, we remain of the view that it will be avoided because Congressional Republicans and Democrats are well aware after the 2013 experience of the blame they will take if a shutdown happens, particularly if it’s over Christmas/New Year. There have been 12 shutdowns since 1981 and their economic impact tends to be modest.
On the data front in the US, expect the National Association of Home Builders Housing Market Index (Monday), housing starts (Tuesday), home sales (Wednesday and Friday) and house price gains (Thursday) to remain solid. Durable goods orders (Friday) are likely to remain in a rising trend and the core private consumption deflator (also Friday) is likely to remain around 1.4% year-on-year.
In Europe, ahead of the Catalan election (Thursday) polls suggest a slight lean against the separatist parties versus anti-independence parties, but if the separatist parties do win a majority the experience of the last few months suggests they are unlikely to make another unilateral independence push.
The Bank of Japan (Thursday) is unlikely to make any changes to monetary policy – growth is looking good but core inflation at 0.2% year-on-year is a long way below target.
In Australia, the Mid Year Economic and Fiscal Outlook (Monday) is likely to show a reduction in the projected 2017-18 budget deficit from $29 billion to around $25 billion largely reflecting stronger than expected corporate tax collections. The minutes from the RBA’s last board meeting are likely to be consistent with the view that the RBA remains optimistic about the outlook but sees no case for an imminent rate hike.
Outlook for markets
With the direction-setting US share market not having had a negative total return month so far this year (a very unusual feat historically) the risk of a decent short term correction in global shares led by the US is high. Uncertainty around US tax reform and government shutdown risk could provide a trigger, but given positive seasonality with “Santa Claus”-related strength usually kicking in from mid-December, a correction is likely to wait till next year. Looking beyond short-term correction risks though, we remain of the view that the broad trend in shares will remain up because we are still in the sweet spot in the investment cycle – with okay valuations, solid global growth and improving profits but still benign monetary conditions.
Australian shares are likely to continue to participate in the global share rally, albeit remaining a relative laggard thanks to a more constrained earnings outlook.
Low starting-point government 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.
The Sydney and Melbourne residential property markets are likely to slow further over the next year or two, with prices likely to fall by around 5-10%. But Perth and Darwin are 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 2.2%.
Expect the Australian dollar to fall to around US$0.70. With the RBA on hold for the next year or more and the Fed on track to continue hiking next year, the interest rate differential will continue to move against Australia, which should result in further weakness in the A$.