7 April 2017
Share markets were mixed over the last week with ongoing nervousness regarding whether President Trump will pass his pro-business reforms, the Fed signalling a likely start to reducing its balance sheet later this year and a US missile strike against Syria injecting a bit of uncertainty. US shares fell 0.3%, Eurozone and Australian shares were flat, Japanese shares lost 1.3% but Chinese shares rose 1.5%. Bond yields and the A$ fell, but oil and gold prices rose.
While the US missile strike against Syria in response to a chemical attack on its civilians caused a bit of uncertainty in financial markets, it looks to have been trivial and short-lived as has been the case in the past in response to limited military strikes and most terrorist attacks. This is likely to remain the case as the strike was highly targeted and proportional to the chemical attack and does not signal increased US involvement in Syria. One thing it does tell us though is that the US is not withdrawing into isolationism under President Trump as some feared and that is a good thing.
In terms of the policy progress around President Trump: the resurrection of debate around healthcare reform is a negative in that it could delay tax reform but a positive in that if it’s successful it can result in budget savings that make tax reform easier; the change to Senate rules to allow a simple majority of 51 to approve Neil Gorsuch to the Supreme Court will further enrage Democrats and risk more gridlock long term but is unlikely to have much impact in the short term as the GOP has the 51 Senate votes; talk of bringing back Glass-Steagall bank regulations won’t go anywhere as there is no support for such a move in the US Congress; the meeting between Presidents Trump and Xi looks to have been focussed on getting to know each other with Trump referring to an “outstanding” relationship with Xi and that lots of “bad problems will be going away” but at least the risk of a Trump-driven trade war will remain on the back burner. In short lots of noise around all this – but as long as Mr Trump’s pro-business agenda remains the focus investment markets won’t be too fussed.
The US Federal Reserve signals that the third phase of monetary policy normalisation – ie, balance sheet reduction – is likely to get underway from later this year. The first phase was the tapering and then ending of quantitative easing or QE between January and October 2014, the second was the start of interest rate hikes in December 2015 and the third will be letting its balance sheet start to decline with the minutes from last month’s Fed meeting indicating that this is likely to be appropriate from later this year. The Fed has long signalled that this will be achieved by not reinvesting (or rolling over) the proceeds from maturing bonds in its balance sheet and from the Minutes it looks to favour a phasing down of its reinvesting. The start of the first two phases in moving to more normal monetary policy were associated with corrections in share markets (the “taper tantrum” of mid-2013 and the correction in share markets between May 2015 and February 2016) as investors fretted the Fed will automatically wind back stimulus regardless of the economic impact. So there is a risk of something similar happening in the months ahead particularly given that share markets have been vulnerable to a correction for some time. However, there is no reason to get too fussed:
- First, as the first two phases showed the Fed will not blindly start to run down its balance sheet but it will be contingent on a continued improvement in the US economy so it’s likely to be gradual and subject to stopping and starting if needed.
- Second, balance sheet run down is likely to be a substitute for rate hikes so if it starts this year it adds to confidence the Fed will only do two rate hikes this year and not three.
- Finally, while it will involve a net increase in the supply of bonds in the market and so along with further rises in US interest rates points to a resumption of rising bond yields – the Fed won’t be actually selling bonds so the rise in bond yields is likely to be gradual.
The bottom line though is that Fed balance sheet reduction along with the end of quantitative easing and rate hikes signal that the Fed’s efforts to support the US economy since the GFC have worked and that it’s appropriate to continue to take it off life support. This is a good thing.
In contrast to the Fed, the ECB and Bank of Japan are yet to start even the first phase of monetary policy normalisation. Relative monetary policy still points to a strong US$ against the Yen and Euro and against the A$ with the RBA on hold.
The first round of the French presidential election is now only two weeks away on April 23rd. Polls continue to show Le Pen and Macron on around 25% of the vote each. So it remains likely they will make it through to the run-off on May 7 where polls show Macron leading Le Pen by around 20%.
RBA on hold and likely to remain so well into 2018. As widely expected the RBA left the cash rate on hold at 1.5% for the eighth month in a row. The uncomfortably hot Sydney and Melbourne property markets along with RBA expectations that GDP growth will return to around 3% and that underlying inflation has bottomed argue against a rate cut. Against this, high unemployment and underemployment, the too high A$, fragile economic growth and downside risks to underlying inflation all argue against a hike. Meanwhile, bank rate hikes, regulatory moves to tighten lending standards and hopefully action in the May budget on the capital gains tax discount should help deal with financial stability risks around house prices and household debt giving the RBA flexibility to set rates in the best interest of the wider economy and not just the Sydney and Melbourne property markets. Our view is that rates have probably bottomed and that the next move will be a hike but not until the second half of 2018.
The drip feed of negative news flow – bank rate hikes, tightening measures by APRA and ASIC, talk of increased bank capital requirements which will result in more out of cycle rate hikes and authorities and commentators warning about the risks – should at least help slow the Sydney and Melbourne property markets. For investors who think that the 10-15% pa average home price gains of the last 4-5 years are a guide to the future its worth having a look at Perth home prices which are where they were ten years ago. Ten years of zero capital growth in Sydney and Melbourne would mean a housing return of just the net rental yield which is 2% or less.
Major global economic events and implications
US data was mostly solid with still strong readings for ISM business conditions indexes, strong jobs data apart from payroll employment, a rise in construction spending and a better than expected trade deficit. A fall in auto sales and weak payroll employment growth of just 98,000 in March were the main negatives. However, the slowdown in payroll employment looks weather related and with the household employment survey up strongly and unemployment falling to just 4.5% the Fed remains on track to continue normalising monetary policy but with wages growth running at just 2.7% yoy the Fed will remain gradual.
Eurozone retail sales rose more than expected in February and unemployment continued to fall reaching 9.5%. While unemployment is still high from a growth perspective it’s the direction that counts and its down from a high of 12.1% in 2013.
Japanese business conditions surveys showed further improvement in March and consumer sentiment is up all of which points to reasonable economic growth.
Australian economic events and implications
Australian data highlighted why the RBA needs to remain on hold. On the one hand March house prices rose strongly, the AIG’s manufacturing and service conditions PMIs were solid, job ads rose, building approvals rebounded and the trade surplus rose to a near record. Against this February retail sales were soft, building approvals look to have peaked, the near record trade surplus partly reflected weak imports which is a negative and in any case will fall in the next month or so thanks to Cyclone Debbie’s hit to coal exports and the MI Inflation Gauge showed underlying inflation remaining weak in March.
What to watch over the next week?
In the US, March quarter earnings reports will start to flow with the consensus looking for a 9.7% gain on a year ago which is likely to be exceeded as expectations have been depressed by a high level of downgrades lately. On the data front, expect small business optimism and job openings (Tuesday) to remain strong and March retail sales (Friday) to perk up a bit reflecting strong jobs and confidence readings. March quarter CPI inflation (Friday) is expected to fall back slightly, but core inflation is expected to come in around 2.3% yoy which is around where it’s been for some time.
In China, expect March CPI inflation (Wednesday) to rise to 1.2% year on year after February’s surprise fall to 0.8%, but producer price inflation to slow to 7.5% yoy (from 7.8%) as positive momentum in commodity prices has faded. Trade data (Thursday) is likely to show a slowing in import growth to 20% yoy but a pick-up in export growth to 10% yoy.
In Australia, expect flat housing finance (Monday), continued strength in business conditions according to the NAB business survey (Tuesday), consumer confidence remaining around its long term average (Wednesday) and a 30,000 bounce in employment (Thursday) in March with unemployment remaining at 5.9%. The housing finance data will be watched closely to see whether the surge in lending to property investors continued in February. The RBA’s latest Financial Stability Review is likely to reiterate the Bank’s recent concerns regarding financial stability risks flowing from excessive growth in home prices and household debt – but this is likely to be a bit dated given that the regulators have already moved.
Outlook for markets
Shares remain vulnerable to a short term pull back as investor sentiment towards them is very bullish and a lot of good news has been factored in which has left them vulnerable to any bad news. But putting short term uncertainties aside, with valuations remaining okay, 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.
With the Australian share market having broken decisively above the 5800 level, it now looks like it’s on its way to a retest of the March/April 2015 intraday highs of just below 6000.
Still low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds. At present bond yields are still consolidating after last year’s rise, but a resumption of the bear market is likely at some point in the months ahead seeing a gradual rise in yields.
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 over the medium term.
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$0.78 and this may continue for some time. At some point this year though, the downtrend in the A$ from 2011 is likely to resume as the interest rate differential in favour of Australia narrows (as the Fed hikes rates and the RBA holds) and as the Fed eventually moves to reduce its balance sheet and hence narrow measures of US money supply.