23 March 2018
Share markets fell sharply over the last week not helped initially by tech stocks due to a privacy breach at Facebook and then later in the week after President Trump proposed tariffs on US$50bn of imports from China fuelling renewed fears of a trade war. Further changes in Trump’s team with John Bolton replacing HR McMaster as National Security Adviser were also seen as adding to the risk of a more hawkish/less market friendly US foreign policy including towards Iran. And more mayhem around avoiding another government shutdown in the US didn’t help either. Over the week US shares lost 5.9%, Eurozone shares fell 3.4%, Japanese shares fell 4.9% (not helped by a rising Yen), Chinese shares lost 3.7% and Australian shares fell 2.2%. This has taken US shares (down 10% from their January high), Chinese shares (down 11% from their January high) and Australian shares (down 5% from their January high) back to around their February lows and Eurozone shares (down 9% from their January high) and Japanese shares (down 15% from their January high) have gone below them. Reflecting safe haven demand, bond yields fell. Commodity prices were mixed though with oil and gold up but copper and iron ore down. The A$ fell but only slightly.
Trump proposes tariffs on around US$50bn of imports from China along with proposed restrictions on Chinese investment in the US and China threatens to hit back with a tariff on US$3bn on imports from the US. It looks scary and the risk of a trade war has escalated, but it’s not necessarily on the way. Trumps latest move was well flagged (although share markets didn’t seem to think so!) and flows from a US investigation into the alleged theft of US intellectual property by China. However, while it looks troubled there are grounds for optimism that an all-out trade war between the two countries will be avoided.
First, the US$50bn or so from 25% tariffs that Trump is talking about may not be that significant. It’s a bit unclear what it refers to – 25% tariffs that raise US$50bn of tariff revenue or a 25% tariff on US$50bn of imports from China? If it’s the latter its only US$12.5bn in extra tariff revenue and would amount to an average tariff increase across all Chinese imports to the US (which total US$500bn) of just 2.5% which would actually have a very minor macro-economic impact – eg, less than a 0.05% boost to US inflation.
Second, so far the US tariffs on China are really just a proposal – they have not yet been implemented. The goods affected have yet to be worked out and after that there will a period of public comment, so it could take up to 45 days before they are implemented. So, there is plenty of scope for US industry to challenge them and for a deal with China. In fact, Trump’s aim looks to be a negotiation with China so consistent with The Art of the Deal he is going in hard up front with the aim of extracting something more acceptable to both. The press release from President Trump actually says “…After a period of notice and comment…and consultation…the US Trade Representative shall…publish a final list of products and tariff increases, if any, and implement any such tariffs”. The reference to if any clearly leaves the door wide open to a negotiated solution with China. Just as we saw with his steel and aluminium tariffs, the initial announcement that seemed to apply to all countries has since been softened to exempt several countries including Canada, Mexico, the EU, Australia, Brazil and Korea.
Third, despite China’s planned retaliation (which with tariffs on US$3bn of imports from the US is tiny!), it looks open to negotiation with Chinese Premier Li a few days ago acknowledging that China’s trade surplus is unsustainable, talking of tariff cuts and pledging to respect US intellectual property. While the Chinese Ambassador to the US has said “We are looking at all options”, raising fears China will reduce its purchases of US bonds, Premier Li actually played this down earlier in the week and doing so would only push the US$ down/Renminbi up which would add to the tariffs in making Chinese exports less competitive. Its arguably in China’s interest to remain calm, do little on the retaliation front and try to come off as the good guy.
Finally, despite what he says in his tweets, a full-blown trade war is not in Trump’s best interest either as it will mean higher prices in Walmart and hits to US exports like Harleys, Jack Daniels, cotton, pork and fruit that will not go down well with his base and he likes to see a higher, not lower, share market. As a result, a negotiated solution with China looks to be the more likely outcome. That said trade is likely to be an ongoing issue causing share market volatility in the run up to the US mid-term elections with Trump again referring to more tariffs. So, while we may not see a full-on trade war, we won’t see trade peace either.
Out of interest US$50bn would be 10% of Chinese exports to the US and 2% of its global exports. Australia is vulnerable to a US/China trade war as 33% of our exports go to China (mostly raw materials) with some turned into goods that go to US. The impact on Australia may be less than feared if the US tariffs, as flagged, focus on aerospace, IT and machinery. That said it’s in Australia’s interest to do the best it can to work with both our partners to help head off any trade war.
Fed more upbeat and we continue to expect four rate hikes this year. Another 0.25% rate hike was no surprise and supporting this the Fed noted that the economic outlook has strengthen and revised up its growth and inflation forecasts and its expected interest rate increases over the next three years. While the median Fed official still sees three hikes this year it will only take one more official to move up to see the median move to four which is likely to happen in June. US monetary policy is a long way from being tight and so is a long way from threatening US growth, but it’s still likely to be a source of market volatility this year and a constraint on share market returns. For Australia, the RBA is a long way from following the Fed thanks to there being much more spare capacity in the Australian labour market and hence much weaker wages growth and so we don’t see the RBA starting to raise rates until early next year. So while rising US interest rates risk some upwards pressure on Australian bank funding costs and hence maybe on fixed mortgage rates, for owner occupier variable rates this is likely to be offset by continuing low official interest rates in Australia. For the A$, the now negative interest rate gap versus the US which is likely to blow out to near 1% by year end, points to downwards pressure on the A$.
Major global economic events and implications
US business conditions PMIs fell this month but remained in the solid range they have been in for the last 18 months and the leading index, durable goods orders and existing home sales were strong. While Friday saw a bit of drama around the risk of another Government shutdown, with Trump initially refusing to sign a bill providing funding for six months (on the grounds that there was no solution for the wall or Dreamers – so much for the “bill of love”!) he ultimately signed it. So at least there is no shutdown.
Eurozone business conditions PMIs slipped in March, possibly suggestive of a dampening impact from trade war fears and from the stronger Euro. That said they remain strong and consumer sentiment remained unchanged at a high level.
Japan’s manufacturing conditions PMI also slipped in March but remains relatively high. Meanwhile core inflation edged up to 0.5% year on year in February (from 0.4%) as expected, but it’s still a long way from the 2% target so the Bank of Japan’s easy money program still has a long way to go.
China raises interest rates, but not enough to get excited about. The PBOC increased its key 7-day money market rate by 5bp to 2.55%. It’s likely part of the deleveraging effort and also to contain capital outflows after the latest Fed hike, but it’s hard to get excited as it was only 5bps! Meanwhile, China’s moves to reorganise and streamline government departments and regulators, a new leadership team of four vice-premiers and the appointment of former PBOC deputy governor Yi Gang as governor are all consistent with pursuing President Xi Jinping’s reform agenda. Yi Gang’s appointment in particular signals continuing support for retiring PBOC Governor Zhou’s policies to open the economy and modernise monetary policy.
Australian economic events and implications
In Australia, jobs growth remained strong in February but it’s just keeping up with labour force growth. The good news is that employment is up a very strong 3.5% over the last year, full time jobs are up by 4% and leading labour market indicators like job vacancies and hiring plans point to continued strength. Against this, unemployment is trending sideways as rising participation and strong population growth boost the labour force and worker underutilisation remains very high at just below 14%. All of which points to wages growth remaining low and the RBA staying on hold.
Which is what the minutes from the RBA’s last meeting implied it is likely to do. However, there were two things of interest in the minutes. First, the RBA appears to have paved the way for a downgrade to its growth forecasts for this year indicating that it expects growth to be above potential which at around 2.75% or so is a lower hurdle than its previous description of above 3%. Second, the RBA is not too fussed by the reset of interest only to principal and interest loans noting that the schedule of resets will be little different from recent years and while it would be significant for individual households the aggregate impact on consumer spending is likely to be small.
Meanwhile, Australian population growth remains strong at 1.6% year on year in the September quarter last year. This was led by Victoria at +2.4%yoy helping explain the resilience of the Melbourne property market, the ACT at 1.8%yoy, Queensland at 1.7%yoy (likely to be next to see faster property prices?), NSW at 1.6%yoy, WA at +0.9%yoy, Tasmania at 0.7%yoy and NT flat. Clearly this is a boost to overall economic growth (albeit its per capita growth that counts and we aren’t doing so well on that front) and to underlying housing demand which combined with a failure to boost housing supply until recently to match underlying demand explains why housing is so poorly affordable in many Australian cities.
What’s the risk of a Banking Royal Commission induced credit crunch? We are only two weeks into the Royal Commission, but it seems a real risk around the issues of lax lending standards is that banks move to a far more rigorous assessment of applications for loans – in terms of each applicant’s income, expenses, assets and other debts. This is most unlikely to cause a full-on credit crunch, but the end result could be much tougher lending standards and a slowing in credit growth. Its early days yet but it’s worth keeping an eye on. It could serve to further delay any move to higher interest rates by the RBA, into say 2020.
What to watch over the next week?
In the US, the focus will be back to inflation with the Fed’s preferred inflation measure, the core private consumption deflator, for February to be released on Thursday likely to show a small rise in annual inflation to 1.6% year on year, but with some pick up in short term momentum. While personal spending is likely to have been soft, disposable income growth is likely to be strong pointing to a pick-up in spending ahead. Meanwhile expect consumer confidence to be strong, home price growth to remain solid (both due Tuesday) and pending home sales (Wednesday) to show a bounce back.
Eurozone economic confidence readings (Tuesday) for March are likely to have slipped, but remain strong.
Japanese data for February (Friday) is likely to show a bounce in industrial production and continuing labour market strength.
Chinese business conditions PMIs will be released Saturday.
In Australia, it’s going to be a relatively quiet week with ABS job vacancy data for February likely to show continued strength and credit growth (both due Thursday) likely to remain moderate.
Outlook for markets
Volatility in share markets is likely to remain high and further weakness is possible as US inflation and interest rates move up and as issues around President Trump and trade continue to impact, but the medium-term trend in share markets is likely to remain up as a global recession is unlikely and earnings growth remains strong globally and solid in Australia. We continue to expect the S&P/ASX 200 Index to reach 6300 by end 2018 – it might just take a bit longer to get back on the path up to there.
Low yields and capital losses from rising bond yields are likely to drive low returns from bonds.
Unlisted commercial property and infrastructure are still likely to benefit from the search for yield by investors, but it is waning, and listed variants remain vulnerable to rising bond yields.
National capital city residential property price gains are expected to slow to around zero as the air continues to come out of the Sydney and Melbourne property boom and prices fall by around 5%, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms.
Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.
The A$ is likely to fall as the gap between the RBA’s cash rate and the US Fed Funds rate pushes further into negative territory. Trade war fears could also drive it lower. Solid commodity prices should provide a floor for the A$ though – in contrast to early last decade when the interest rate gap was negative and the A$ fell below US$0.50
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