Investment markets and key developments over the past week
Most global share markets fell over the last week on the back of the political crisis around President Trump.
US shares fell 0.4% after recovering some of their losses later in the week, Eurozone shares fell 1.1%, Japanese shares fell 1.5% and Australian shares fell 1.9%.
Australian shares are now down around 4% from their high earlier this month and have been hit by the weak global lead combined with pressure on the banks as a result of the Budget’s bank levy along with expectations for slowing credit growth and weakness in retailers on the back of weak retail sales and fears around the competitive threat from Amazon.
Chinese shares managed to buck the global trend and see a 0.6% gain.
Reflecting the risk off environment bond yields generally fell, but commodity prices mostly rose helped by a falling US dollar.
The weaker US$ and good jobs data also helped support a small bounce in the A$.
The standard narrative right now seems to be that the ‘Trump trade’ drove the surge in global share markets since the US election and that this will now reverse because of the political crises now surrounding President Trump.
This is too simplistic and likely to be wrong.
First, the main reason for the rally in shares since last November has been the improvement in economic conditions and surging profits that has occurred globally and not just in the US and which had little to do with Mr Trump.
Second, the political crisis around the President won’t necessarily stop the pro-business reform agenda of the Republicans. In fact, unless things become terminal for Mr Trump quickly it’s more likely to speed it up.
There is no doubt the political risks around President Trump worsened over the last week with increasing talk of impeachment and concern that it will impact the Republican’s tax reform agenda.
However, it’s a lot more complicated than that:
First, impeachment is initiated by the House of Representatives and can be for whatever reason the majority of the House decides and conviction, removal from office, is determined by the Senate and requires a two thirds majority.
At present Republicans control the House with a 21 seat majority and won’t vote for impeachment unless it’s clear that Mr Trump committed a crime (and so far it isn’t obvious that he has) and/or support for him amongst Republican voters (currently over 80%) collapses.
However, Mr Trump’s overall poll support is so low that if it does not improve the Democrats will gain control of the House at the November 2018 mid-term elections and they will likely vote to impeach him (they hate him and will almost certainly find something to base it on much like the Republican Congress found reason to impeach President Clinton) and then it’s a question of whether Mr Trump can get enough support amongst Republican Senators to head off a two thirds Senate vote to remove him from office (Clinton was not removed from office because Democrat and some Republican senators did not support the move to do so).
This is all a 2019 and beyond story anyway, but the point is that Republicans only have a window out to November next year to get through the tax cuts/reforms they agree with Mr Trump should happen.
So if anything, all of this just speeds up the urgency to get tax reform done because after the mid-terms they probably won’t be able to.
Now there is another way for the Vice President and Cabinet to remove a President from office under the 25th Amendment of the Constitution which is aimed at dealing with a President who has become mentally incapable.
While some may claim this one is a no brainer, Vice President Pence is a long long way from doing this.
The bottom line is that while the noise around President Trump and particularly the FBI/Russia scandal will go on for while it does not mean that tax reform is dead in the water.
In fact, unless it becomes obvious that Mr Trump has committed a crime resulting in the Republicans themselves moving to impeach him, it’s more likely to speed up tax reform and other measures that do not require any Democrat support in the Senate.
On this front work on tax reform is continuing including in the Senate and Mr Trump’s infrastructure plan (which is likely to be around leveraging up Federal spending and encouraging states to privatise their assets and recycle the proceeds) looks likely to be announced soon.
The impact of past impeachments on the US share market is mixed and proves little. The unfolding of the Watergate scandal through 1973-74 occurred at the time of a near 50% fall in US shares but this was largely due to stagflation at the time.
(Out of interest President Nixon resigned before he was impeached.) President Clinton’s impeachment had little share market impact but it was in the midst of the tech bull market.
Share markets have had a great run and are due a decent 5% or so correction as a degree of investor complacency (as indicated by an ultra-low VIX reading two weeks ago) has set in and the latest scandal around President Trump may just be the trigger.
North Korean risks are another potential trigger and after all it is May (“sell in May and go away…”). Australian shares are down 4% from their high early this month, but global shares are only down 2% or so.
However, providing the current Trump scandal largely blows over for now allowing tax reform to continue it’s unlikely to derail share markets beyond any short term correction.
Valuations are reasonable – particularly for share markets outside the US, global growth is looking healthier, profits are rising (by around 14-15% yoy in the US and Japan and by 24% yoy in Europe) and global monetary conditions remain supportive of shares.
It seems to have been a week for political scandals. Aside from those around President Trump, a corruption scandal has engulfed Brazilian President Temer highlighting that big risks remain around Brazil and allegations have emerged regarding Japanese PM Abe (although he is likely to survive them).
Major global economic events and implications
US economic data was mostly good. Housing starts fell in April but driven by volatile multi units and a further increase in the already strong NAHB homebuilders index points to strong housing conditions going forward.
While the New York regional manufacturing conditions index fell in May it rose in the Philadelphia region and industrial production rose sharply in April.
Meanwhile, jobless claims remain at their lowest since the early 1970s. All of this is consistent with the Fed hiking rates again next month.
The political noise around President Trump will only impact the Fed if shares and economic conditions deteriorate significantly and that looks unlikely.
The Japanese economy accelerated to 0.5% quarter-on-quarter in March driven by consumption and trade taking annual growth to 1.6% year-on-year.
This was the fifth consecutive quarter of growth, the first such run in 11 years.
Chinese data for industrial production, retail sales and fixed asset investment slowed in April consistent with other data indicating that recent policy tightening is impacting.
Our view remains that GDP growth will track back from March quarter growth of 6.9% year on year to around 6.5%. The Chinese authorities have little tolerance for a sharp slowing in growth and policy makers are already showing signs of easing up on the policy brake.
Meanwhile property price growth seems to have stabilised around 0.5% a month over the last few months, but is still slowing in Tier 1 cities.
Australian economic events and implications
Australian data was mixed.
Jobs growth was strong again in April and forward looking jobs indicators point to continuing strength ahead, but consumer confidence fell and wages growth remained at a record low of just 1.9% year-on-year.
While the good jobs numbers will help keep the RBA on hold for now regarding interest rates the continuing weakness in wages growth is a concern and highlights ongoing downwards risks to growth, inflation and the revenue assumptions underpinning the Government’s projection of a return to a budget surplus by 2020-21.
With unemployment and underemployment remaining in excess of 14% it’s hard to see what will turn wages growth up any time soon.
So while our base case is that interest rates have bottomed, if the RBA is going to do anything on interest rates this year it will more likely be another cut than a hike. Particularly if property price growth slows.
What to watch over the next week?
OPEC meets Thursday and is likely to extend its oil supply cuts in the face of rising US shale oil production. OPEC is in a bind: if it cuts supply further it will lose more market share to shale oil but if it hikes production oil prices will plunge again.
In the US, in the week ahead expect the minutes from the last Fed meeting (Wednesday) to remain consistent with another rate hike at the Fed’s June meeting and the Market manufacturing conditions PMI for May (Wednesday) to show a slight improvement from April’s reading of 52.8.
New home sales (Tuesday) and existing home sales (Wednesday) are expected to fall back slightly after strong gains in March, home prices (Wednesday) are expected to show a further gain and April durable goods orders (Friday) are expected to remain consistent with continued reasonable growth in business investment.
March quarter GDP growth (Friday) is likely to be revised up to 0.9% annualised from an initially reported 0.7%.
In Europe, expect May business conditions PMIs (Wednesday) to remain strong consistent with stronger economic growth.
Japanese core inflation for April (Friday) is expected to remain around zero consistent with the Bank of Japan maintaining a zero 10-year bond yield and quantitative easing for a long time.
In Australia, March quarter construction data is expected to show continued softness in mining related engineering construction but gains in residential and non-residential construction.
Speeches by RBA officials Debelle, Bullock & Richards will be watched for any clues on interest rates.
Outlook for markets
Shares remain vulnerable to a further short term setback as we are now in a weaker seasonal period for shares with risks around President Trump, North Korea, Chinese growth and the Fed’s next rate hike next month providing potential triggers.
However, with valuations remaining okay – particularly outside of the US, global monetary conditions remaining easy and profits improving on the back of stronger global growth, we continue to see any pullback in shares as an opportunity to “buy the dips”.
Shares are likely to trend higher on a 6-12 month horizon.
Low yields and capital losses from a gradual rise in bond yields are likely to see low returns from sovereign bonds.
Unlisted commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this demand will wane as bond yields trend higher.
National residential property price gains are expected to slow, as the heat comes out of Sydney and Melbourne.
Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.
For the past year the A$ has been range bound between US$0.72 and US$0.78, but our view remains that the downtrend in the A$ 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) and constrained commodity prices will also act as a drag.
Expect a fall below US$0.70 by year end.