Investment markets and key developments over the past week
Global equities finished the week higher with US shares up by 1.4%, Australia +1.1%, Eurozone +1.9%, Japan +1.1% and China +1.3%.
Markets benefitted from the slightly dovish tone to US Federal Reserve Chair Yellen’s testimony before Congress.
US 10-year bond yields are slightly lower over the week while commodities like oil and iron ore are firmer.
Central bank activity dominated markets again this week.
Yellen’s testimony before Congress very much stuck to the script of recent Fed communication, but did have some dovish undertones.
Yellen emphasised that monetary policy adjustment would be “gradual”, that interest rates would be lower compared to history because the “neutral” level of the policy rate (the interest rate level that is neither expansionary or contractionary) has fallen and she also noted that while softer inflation readings recently warranted watching, the influences dragging inflation lower look to be temporary (for now).
We think the Fed is still likely to raise interest rates once more this year (totalling three hikes in 2017 – in line with the dot plots in the Fed’s projections), but the rate hike will probably happen in December (rather than at the September meeting) because of the softness in inflation and wage outcomes recently.
Markets are not yet fully pricing the chance of another hike before the end of 2017.
Yellen also noted that balance sheet normalisation (the process of slowly reducing the central bank’s balance sheet) will need to be implemented soon through slowing the reinvestment of maturing assets.
Yellen noted that this process will also occur gradually, giving private investors enough time to absorb these assets in the market, thereby not putting too much sudden upward pressure on bond yields.
We think the Fed is likely to announce this normalisation at its September meeting – before the next interest rate hike. Although interest rate hikes and balance sheet management are two separate and different monetary policy tools, there is a risk that using both policy levers at the same time may cause unwanted market disruptions in the current economic environment.
While interest rate adjustments are conditional on (predominately) inflation and employment outcomes, balance sheet roll off is not conditional on these indicators meeting the Fed’s expectations.
The actual impact of balance sheet normalisation on the economy will be felt less in the economy than an interest rate hike.
On our estimates, total balance sheet run-off in 2018 would equate to around 1.5 rate hikes (or around 40 basis points).
The Bank of Canada (BoC) followed up on it recent hawkish commentary by hiking interest rates for the first time in seven years to 0.75% (but this rate rise was expected by markets).
Better than expected GDP growth recently has narrowed the output gap (the difference between actual and potential growth) which allows for higher interest rates.
The Australian and Canadian economies have some similarities in economic performance lately (both are very reliant on commodity exports and have recently experienced a significant house price boom) so the risk is that there could be an expectation for the Reserve Bank of Australia (RBA) to turn hawkish.
But we do not see the BoC hike as an early sign of near-term RBA rate rises.
We see three key differences between the Australian and Canadian economies that will keep the Reserve Bank of Australia on hold for now:
Policy rates are still lower in Canada (at 0.75% vs Australia at 1.50%).
The BoC cut the policy rate twice in 2015 as an “insurance” cut to the significant oil price slump and are now playing catch-up to normalise rates.
Australia is still in the end of a mining capex decline which will act as a drag on growth while Canadian growth has been increasing over the past year.
The Canadian economy is most reliant on the US economy (where growth is lifting) as its major trading partner while Australia is most reliant on China (where growth is slowing).
These factors argue for a cautious RBA for now. Currently, the market expects that the BoC will lift interest rates to 1.50% in a year’s time.
The risk is that hikes are less frequent, as has been the experience with the Fed given global low inflation and wages growth.
Major global economic events and implications
US data was mixed. The beige book saw most districts report a “modest” or “moderate” pace of growth with more signs of a tightening labour market leading to some wage pressures.
NFIB small business optimism was a little weaker in June, but still remains well above pre-election outcomes, producer prices were firmer in June, but Bloomberg consumer confidence was weaker over the past week.
Retail sales disappointed in June and consumer price data was weak over the month.
The government’s healthcare reform plan (Affordable Care Act) is still in play, with the new Senate version of the legislation released this week.
We think that there is a good chance that healthcare reform will be agreed upon before the recess in mid-August, giving more hope for taxation reform changes.
In the Eurozone, May industrial production was higher.
The UK unemployment rate fell to its lowest level since 1975.
Chinese consumer price inflation data was weak in April while producer prices were unchanged which may weigh on concerns over the current tightening cycle.
Credit growth is slowing because off-balance sheet lending is weakening from macroprudentiual controls and financial tightening.
New yuan lending (on-balance sheet financing) is still rising.
On face value, China is managing to rein in and de-lever the risky parts of the economy whilst still managing to keep growth and activity at a respectable level which argues for stable growth in the near-term. Chinese trade data was good, with surging export and import growth in June lifting the trade balance.
In Japan, data was mixed with machine orders down in May but bank lending was up solidly in June.
Australian economic events and implications.
Australian consumer confidence rose marginally in July, but remains negative while the NAB business survey showed another strong outcome for business conditions and confidence (conditions are now around the pre-financial crisis highs) which has been the story over the past three years
Housing lending was up for owner-occupiers in May but down for investors as macroprudential tools that lifted investor loan rates are starting to be felt.
What to watch over the next week?
In the US, housing indicators are due including the July NAHB housing market index and June housing starts.
The quarterly US reporting season is also underway with expectations of the rebound in profit growth over the past year continuing.
Chinese second quarter GDP data will be important and should show growth tracking around 6.8% – a solid outcome. Retail sales, fixed asset investment and industrial production data is also due and should show unchanged growth on the prior month.
In New Zealand, the second quarter consumer price inflation is expected to remain low at 1.9%pa.
New Zealand inflation readings are often a good guide to Australian inflation.
The Australian June employment numbers should show moderate employment growth (+10K over the month), in line with leading indicators of the labour market.
The unemployment rate is expected to rise marginally to 5.6%, but this is still lower than a year ago. The July RBA Board minutes are not likely to have a hawkish tone given that the post-meeting statement in July was fairly neutral.
Rate hikes from the central bank are still a fair while away, with risks around the consumer and housing story preventing higher rates. We still see more risks to rate cut than a hike in the near-term.
Eurozone June consumer price data should show a stabilisation in core inflation at current levels (which is still low, but no longer falling).
The European Central Bank (ECB) is not expected to change its monetary policy stance at next week’s meeting.
President Draghi’s hawkish comments recently referred to the pickup in Eurozone growth which was continued well into 2017, but it is still too early for the ECB to consider phasing out its asset purchase program or lifting interest rates.
Stronger growth in Europe will ultimately drive underlying inflation higher which should lead to a tapering in the ECB’s quantitative easing program – probably through 2018 – this is likely to be announced around September this year.
The BoJ is expected to keep monetary policy settings unchanged next week after committing to continuing quantitative easing and targeting a yield of 0% on 10-year bonds last September.
Growth in Japan has improved noticeably over the past year but low inflation is still a problem.
Outlook for markets
Shares are vulnerable to a further short term setback as we go through the seasonally weak September quarter with the back up in bond yields on central bank exit talk looking like it has further go and risks remaining around Trump and North Korea.
However, valuations remain mostly okay – particularly outside of the US, global monetary conditions are set to remain easy and profits are improving on the back of stronger global growth, so we continue to see the broad 6-12 month trend in shares remaining up.
Australian shares are likely to end the year higher but will likely remain relative underperformers compared to global shares. Low yields and a gradual uptrend in them point to low returns from sovereign 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.
National residential property price gains are expected to slow, as the heat comes out of Sydney and Melbourne. Perth and Darwin are near the bottom and other capitals are likely to see moderate growth.
Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.
Our view remains that the downtrend in the A$ from 2011 will resume this year.
The rebound in the A$ from the low early last year of near US$0.68 has lacked upside momentum, the interest rate differential in favour of Australia is continuing to narrow and will likely reach zero early next year (as the Fed hikes rates and the RBA holds).