Investment markets and key developments over the past week
Share markets rebounded over the last week, as share investors became a bit more relaxed about the prospect of higher inflation and interest rates and the unwinding of ‘short’ volatility trades ran its course. However, the rebound has been concentrated in the US share market, which rose 4.3% over the last week (and is up 7% from its recent low), with Europe up 3.2% over the week, Japan up 1.6% and Australia up 1.1% – all lagging.
Chinese shares rose 3.3%, in a shorter trading week due to the Chinese New Year holiday.
The Australian share market didn’t fall as much on the way down, but a resumption of the falling US dollar likely played a role in the relative outperformance of US shares over the last week as it boosts US profits and constrains profits in Europe, Japan, Australia and other markets.
Bond yields were up a bit over the week in the US and Australia, but fell slightly in Europe and Japan. Commodity prices and the Australian dollar rose, helped by renewed US dollar weakness and as investor confidence returned, although the gains were curtailed a bit as the US$ recovered some of its losses late in the week.
While share markets have settled down to varying degrees, the strength of the US economy, coupled with fiscal policy providing an additional boost, is likely to ensure that inflation will be a growing issue this year globally.
We remain of view that market expectations regarding US Federal Reserve (the Fed) rate hikes are too complacent.
The next chart shows that US money market rate hike expectations are still well below what the Fed has signalled, hence a further shifting up in market interest rate expectations is likely, and this will drive a further rise in bond yields.
Strong earnings growth, and the absence of a recession on the horizon as US monetary policy is still easy, should allow share markets to trend higher this year, but rising US inflation, interest rates and bond yields will make for ongoing bouts of volatility and a more volatile and constrained ride than we became used to last year.
President Trump’s proposed 2019 Budget – with US$200 billion in infrastructure funding over ten years (including an asset recycling plan), but a 2% cut to domestic spending – is of little relevance. Congress decides the budget, not the president, and at present it’s focussed on the deal just passed to increase spending by $300 billion over the next two years.
That deal already included some increase in infrastructure spending, but only for two years, which represents half of what Trump is looking for.
So yes, there will increased infrastructure spending in the US in the years ahead, but nowhere near as much as Trump has promised.
Meanwhile, Senate efforts to find a solution for Dreamers looks to have floundered for now, keeping alive the prospect of another Government shutdown next month.
We remain of the view that, if there is one, it will be short given the political damage it could cause the Democrats.
Meanwhile political risks in the US flowing from the Mueller inquiry continue to rise.
While it has unveiled details of alleged pro-Trump, anti-Clinton meddling by Russia in the 2016 election, it’s said to be still investigating whether there was collusion between the Trump campaign and Russia.
Our view hasn’t changed: the Republican-controlled House of Representatives won’t commence impeachment proceedings against Trump unless there is clear evidence of wrong doing; the Democrats may, if they get control of the House after the mid-terms.
However even if they do, impeachment is unlikely to be supported by the required 70% Senate majority, and even if Trump is ultimately removed Vice President Pence will take over, and his policies won’t be much different.
However, if the pressure on Trump picks up significantly, the main risk would be if he chooses to lash out and take a more populist policy path – for example, to intensify trade conflict with China, or conflict with Iran or North Korea – as a distraction.
With the Commerce Department recommending import tariffs on steel and aluminium, after tariffs were imposed on solar panels and washing machines a few weeks ago, the risks of a trade war are clearly already on the rise.
Our view remains that China will take a measured approach in response, and so a full -blown trade war will be avoided, but it’s worth keeping an eye on.
Bank of Japan Governor Kuroda’s nomination for another term, along with the dovish Masayoshi Amamiya and ultra-dovish Masazumi Wakatabe as deputies, and comments by Prime Minister Abe and his advisers indicate that the Bank of Japan is unlikely to ease up on its monetary policy stimulus any time soon and may if anything be biased towards more easing to stop or reverse the rise in the yen.
This is particularly a consideration with the yen rising sharply and technically looking like it’s on its way up to the 2016 high of ¥100 to the US$.
Major global economic events and implications
Confusing US economic data – but forget stagflation worries.
A stronger-than-expected rise in CPI inflation, with January core inflation up 0.3% month-on-month or 1.8% year-on-year and running at an annualised 2.6% over the last six months, coupled with a rising trend in producer price inflation and imported inflation, reinforces our expectations for rising US inflation this year.
However, last year also saw a stronger-than-expected rise in inflation in January, which then slowed again, and some of the components that rose strongly look a bit noisy, so it would be premature to get even more bearish on inflation.
More importantly, the surprise fall in January retail sales looks likely to be an aberration that may owe to poor weather, with strong consumer confidence, strong jobs growth, tax cuts and rising wages growth all likely to support strong retail sales going forward. Meanwhile, most other activity-related indicators were strong.
Industrial production slipped in January, however small business optimism, regional manufacturing surveys and home builder conditions are all strong and their components point to strong orders and employment and rising inflationary pressures.
Also keep in mind that housing starts and permits surged in January and consumer sentiment rose, despite recent share market volatility.
Consistent with ongoing strength in the US economy, the December quarter US earnings reporting season continues to impress.
Of the 399 S&P 500 companies to have reported so far, 79% have beaten earnings expectations and 78% have beaten on sales.
Earnings growth for the quarter is tracking up 15% year-on-year and revenue is up 8% year-on-year.
Japanese December quarter GDP growth of just 0.1% quarter-on-quarter was less than expected, but consumer spending was solid and leading indicators point to continued growth ahead.
Australian economic events and implications
As has long been the case in recent years, Australian data was mixed.
On the one hand, business condition and confidence rose in January, according to the NAB survey, and employment rose solidly.
However against this backdrop consumer confidence slipped a bit in February, while the quality of the jobs report was poor with a sharp fall in full-time jobs and slowing hours worked.
On the jobs front, job vacancies and job advertisements point to continued strength, however employment has overshot the strength in jobs’ leading indicators and so may undershoot for a while. More significantly, after a good rebound in full-time jobs last year, we may be reverting back to lower quality part-time jobs as the main driver of employment.
For those trying to understand why the Reserve Bank of Australia (RBA) is lagging behind the Fed in raising rates (apart from the fact that the Fed cut far more than the RBA did in the first place), the chart below is a good place to start. Basically, labour market underutilisation (or unemployment plus underemployment) is far higher in Australia than in the US.
This means it will take longer for wages growth to pick up in Australia and for the RBA to hike rates.
On the interest rate front, RBA Governor Lowe’s Parliamentary testimony basically repeated the Bank’s message of the last few weeks which is that the next move on rates will most likely be up, the economy is moving in the right direction, we have seen more positive economic news in recent months, but uncertainty remains around the consumer and progress in reducing unemployment and having inflation return to target is likely to be gradual.
As such the RBA “does not see a strong case for a near-term adjustment of monetary policy”. We agree, and don’t see a rate hike until late this year at the earliest.
It’s still early days in the profit reporting season for the December half, with only a third of companies having reported, but so far it remains reasonably good.
Thus far, 46% of results have exceeded expectations against the average of 44%, 74% have seen profits rise from a year ago and 72% have increased dividends from a year ago.
However, only about 49% have seen their share price outperform on results day, and there is still a way to go yet, with results often tailing off a bit as more report.
What to watch over the next week?
In the US, the minutes from the last Fed meeting (Wednesday) are likely to attract greater than usual attention but are likely to do little more than affirm that the Fed is on track for another rate hike next month.
Meanwhile, expect the Markit business conditions PMIs for February to have remained solid and existing home sales to gain (also both due on Wednesday).
Eurozone business conditions PMIs for February will also be released on Wednesday and are likely to have remained strong.
In Japan, the manufacturing PMI for February (Wednesday) is likely to have remained strong but core inflation for January (Friday) is likely to remain around 0.3% year-on-year which is well below the 2% target and will prevent any imminent easing in easy money from the Bank of Japan.
In Australia, the minutes from the RBA’s last board meeting (Tuesday) are likely to confirm that it’s a bit more upbeat, but that with the move back to the mid-point of the inflation target likely to be gradual, it’s in no hurry to raise interest rates.
December quarter wage data to be released on Wednesday are likely to show wages growth of just 0.5% quarter-on-quarter or 2% year-on-year, consistent with the RBA remaining on hold for some time.
Meanwhile, December quarter construction activity data (also Wednesday) will likely fall back after a strong gain in the September quarter.
The Australian December half 2017 earnings reporting season will really ramp up in the week ahead with around 80 major companies reporting including Seek (Monday), Oil Search and BHP (Tuesday), Worley Parsons, Wesfarmers, Lend Lease and Fairfax (Wednesday), Qantas and Crown (Thursday) and Woolworths (Friday).
This reporting season is expected to see a fall back to single digit earnings growth (after the resource-driven surge seen in 2016-17) with overall earnings growth around 7% (compared to around 16% in the last financial year), with resources profit growth slowing to around 14% (from 130% in 2016-17) but still supported by solid commodity prices and production growth, bank earnings growing around 3% and industrials up 5% with strong results for insurers, utilities, healthcare, building materials and consumer discretionary.
The main themes will be continued strength in companies exposed to housing construction and the infrastructure spending boom, the impact of the US tax cut on companies exposed to the US and the potential for some special dividends and capital returns.
Outlook for markets
Ongoing strong economic and profit growth and still easy monetary policy should keep investment returns favourable, but stirring US inflation, more aggressive Fed hikes and a possible increase in political risk are likely to constrain returns and keep volatility up after the stability of 2017
Share market volatility has not gone away, despite the relative calm of the last week, but shares are still likely to trend higher this year as global recession is unlikely and earnings growth remains strong globally and solid in Australia.
We remain of the view that the S&P/ASX 200 index will reach 6,300 by end 2018.
Low yields and capital losses from rising in bond yields are likely to see 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 are 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%.
After reaching as high as US$0.8136 which is near the top of the technical channel it’s been in since 2015, the A$ is on the way back down again against the US$, and this is likely to get a push along as the gap between the Fed Funds rate and the RBA’s cash rate goes negative next month. Solid commodity prices will provide a floor for the A$ though.