Investment markets and key developments over the past week
There was plenty of action in markets over the past week with lots of noise and anticipation over future central bank action.
US equities were up by 1.6% over the week, Euro stocks increased by 0.4%, Japanese equities were down 0.2%, Chinese equities lifted by 2.1% and Australian shares were down 0.9%.
Global bond yields lifted this week with the US 10 year yield at 2.54% – back to March 2017 levels.
However the US dollar didn’t budge higher and fell by 1.1% over the week.
European bond yields lifted, particularly in Germany and France, as markets read the latest commentary from the European Central Bank (ECB) as hawkish, which also pushed the euro higher.
Japanese bond yields and the yen rose on speculation that the Bank of Japan (BoJ) was going to tighten monetary policy.
Commodity prices remained elevated, particularly oil prices, which are sitting at nearly US$70/barrel on concerns over tensions between the US and Iran and some recent supply constraints.
Energy stocks have also benefited from higher oil prices.
The latest moves in the oil price are unlikely to be a hindrance on global growth.
However the moves will lift headline inflation in the near-term.
The news that the BoJ was trimming its purchases of government bonds was taken by investors as a sign of monetary policy tightening.
However the central bank didn’t actually give any formal guidance around its policy stance, so the news looks to have been slightly misinterpreted by markets.
The BoJ is far from tightening interest rates, with its current policy of negative interest rates and targeting the bond yield working well. Inflation is still closer to 0%, rather than the 2% target, so a change to the current monetary policy stance is some time away.
The appreciation of the yen this week may have more upside, as Japan’s current account surplus remains high.
Reports that China is looking to buy less US bonds also caused a further leg up in bond yields, but there is no sign that this has actually been adopted as official Chinese policy (and is also not the first time that a story like this has been released).
Reports around the BoJ and China are mostly noise but we still think that bond markets are vulnerable this year as global growth improves and inflation lifts (particularly in the US) which will put upward pressure on bond yields.
The ECB December meeting minutes were read as hawkish. It appears that the Governing Council is preparing markets for a future adjustment to monetary policy with the minutes indicating “the Governing Council’s communication would need to evolve gradually…if the economy continued to expand and inflation converged…towards the Governing Council’s aim”.
It was noted that the current stance of monetary policy (the ECB’s asset purchase program) was in line with policy that was better suited to crisis mode.
The ECB’s current bond buying program is due to continue at a pace of €30 billion per month until September 2018. We do not read the latest commentary as a sign of a change in ECB policy.
While the ECB will want to start thinking about eventually lifting interest rates, it’s still too early for the Eurozone to absorb tighter monetary policy, particularly as core inflation is low.
There was more chat from US Federal Reserve officials about potentially adopting a different monetary policy targeting mechanism with the latest talk about price-level targeting, which was recently mentioned by San Francisco Fed President Williams as well as the former Federal Reserve Chair Bernanke.
A price-level monetary policy target will aim to maintain a certain level of prices, rather than price growth (which is what the current inflation-rate target does).
In practice, a price level target would mean that the central bank would be more reactive to deviations from the price-level because it would not look through temporary deviations from an inflation rate (as is currently done).
This would also mean that inflation would tend to be more volatile with periods of very low inflation (or deflation) followed by periods of high inflation to make up for prior misses.
It is generally thought that price-level targeting will favour a “lower for longer” approach in monetary policy which suits the current environment as the US Federal Reserve has been noticeably shy of its 2% inflation target for years.
The discussion has come about as policymakers consider tools available in the case of an economic downturn.
While the US Federal Reserve may explore its options around its monetary policy framework and what other tools are available to it, a change to its current framework is unlikely in 2018 – which will be the first year for new US Federal Reserve chair Jerome Powell.
Major global economic events and implications
US consumer prices rose by 0.1% in December (as expected) whilst core consumer prices were firmer than expected, rising by 0.3%.
Retail sales rose by 0.4% in December, just missing market expectations but there were some big upward revisions which were taken positively by markets.
US producer prices weakened slightly in December due to a fall in food prices, although there was a big lift in health care costs which may partly translate through to consumer price readings.
A drop in health care costs has been a big negative driver of recent US inflation readings.
Small business confidence declined in December, although still remains at a solid level overall while consumer sentiment was up in the first week of January, according to the Bloomberg consumer comfort index.
Chinese price data was a little weaker than expected, with consumer prices up by 1.8% over the year to December and producer prices up by 4.9%, but this is still well up over the past year.
The improvement in commodity prices has been an important driver of higher producer prices.
In the Eurozone, the labour market continues to improve with the unemployment rate nudging a little lower to 8.7% in November, industrial production up in November and retail sales were a little stronger over the month.
Japanese labour cash earnings were up in November while consumer confidence was a little weaker.
Australian economic events and implications
Negative news around the Australian housing market continues to build, with reports this week that the drop in foreign buyer demand is impacting apartment developers and apartment prices.
While restrictions around foreign buyers are putting downward pressure on prices at the margin, the bigger issue is around the continuing flow of new apartments into the market.
The supply of new homes will continue for now with building approvals soaring in November thanks to a big jump in approvals in Victoria.
This reflects one-off approvals for a few large apartment developments. So, the jump is unlikely to be the start of a sudden re-acceleration in national home construction, which has already been strong for a few years.
Nevertheless, with approvals holding up, the level of construction activity will remain higher than expected in 2018 (see chart below) which is good for growth but negative for apartment prices.
Retail sales jumped up by an unexpected 1.2% in November, with spending driven by new iPhone sales and Black Friday deals.
Despite these one-off impacts, other parts of retail spending were still moderate which indicates that the consumer may not be as soft as feared – especially after some weak retail figures in mid-2017. While we don’t expect a sudden big lift in retail spending in the short-term, there may be an upside risk that the Australian consumer may not act as such a large drag on the economy in 2018.
What to watch over the next week?
In the US, data includes regional manufacturing indices, industrial production, the Fed’s beige book, consumer confidence and various housing indicators like the NAHB housing index, housing starts and building permits.
Friday 19th January is also the deadline for the government to pass another temporary funding agreement to avoid a Government shutdown.
We think a funding package will pass this week.
The Bank of Canada meets next week and markets are anticipating a 0.25% rate hike (the last rate hike was in September 2017), which would take interest rates to 1.25%.
Fourth quarter Chinese GDP should show growth over the year to December tracking at 6.7% (from 6.8%) which would be in line with recent stability in Chinese data.
Industrial production for December is expected to show annual growth of 6.1%.
In Australia, January consumer confidence is released and may show a lift from the new year. Housing loans are likely to decline slightly in November.
The employment figures should show a slight fall in jobs growth over December because of the huge rise in the prior month.
A small fall in employment would still mean strong annual growth in jobs, as well as a low unemployment rate.
Outlook for markets
For 2018, continuing strong economic and earnings growth and still easy monetary policy should keep overall investment returns favourable but stirring US inflation, the drip feed of Fed rate hikes and a possible increase in political risk are likely to constrain returns and increase volatility after the relative calm of 2017.
Apart from the likelihood of more volatility through the year, global shares are likely to trend higher through 2018 and we favour Europe (which remains very cheap) and Japan over the US, which is likely to be constrained by tighter monetary policy and eventually a rising US dollar.
We also favour global banks and industrials over technology-related stocks that have had a huge run. Emerging markets are likely to underperform if the US$ rises as we expect.
Australian shares are likely to do okay but with returns constrained to around 8% with moderate earnings growth. Expect the S&P/ASX 200 index to reach 6,300 by end 2018.
Commodity prices are likely to push higher in response to strong global growth.
Low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds.
Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors.
National capital city residential property price gains are expected to slow to around zero as the air comes 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 at around 2.2%.
After a further short-term bounce higher, the A$ is likely to fall to around US$0.70, but with little change against the yen and the euro, as the gap between the Fed funds rate and the Reserve Bank of Australia’s cash rate goes negative. Solid commodity prices will provide a floor for the A$ though.