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Shane Oliver
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Shane Oliver is head of investment strategy at chief economist at AMP Capital.

Trump crisis likely to speed up US tax reform

Monday, May 22, 2017

By Shane Oliver 

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. They've been hit by the weak global lead, pressure on the banks as a result of the Budget’s bank levy, 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 Trump trade

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 Trump. Second, the political crisis around Trump won’t necessarily stop the pro-business reform agenda of the Republicans. In fact, unless things become terminal for Trump quickly, it’s more likely to speed it up. There is no doubt the political risks around 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: 

  1. First, impeachment is initiated by the House of Representatives and can be for whatever reason the majority of the House decides. Conviction, removal from office, is determined by the Senate and requires a two thirds majority. 
  2. At present, Republicans control the House with a 21 seat majority and won’t vote for impeachment unless it’s clear that 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, 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). Then, it’s a question of whether 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 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.

Tax reform - the bottom line

The bottom line is that while the noise around 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 Trump has committed a crime resulting in the Republican’s 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 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) and 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 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% year on year (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 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 multis 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 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 the March quarter 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 in Sydney and Melbourne 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, expect the minutes from the last Fed meeting (Wednesday) to remain consistent with another rate hike at the Fed's June meeting, and the Markit 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 and 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 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 $US0.72 and $US0.78, 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 $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 $US0.70 by year end.

Eurozone shares rose 0.8% on Friday and the US S&P 500 gained 0.7% recovering some of the Trump related hit to markets seen earlier in the week. Reflecting the positive global lead and a rise in iron ore prices ASX 200 futures rose 0.5% on Friday night pointing to 25 point gain at the open for the Australian share market on Monday. 

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Weekly economic and market report

Monday, May 15, 2017

By Shane Oliver

The last week saw US shares hit a new record high but end the week down 0.4%. Eurozone shares fell 0.5% with a bit of profit taking after the French election, but Australian shares were flat, Chinese shares rose 0.1% and Japanese shares gained 2.3%. Bond yields generally fell slightly in major countries despite good economic data and commodity prices were mixed with oil up (on lower US stockpiles) but copper and iron ore were down. The latter, and a rise in the $US, weighed on the Australian dollar. 

The French election

The French presidential election panned out even a bit better than the polls indicated, with Macron winning 66% of the vote. Coming on the back of the Spanish, Austrian and Dutch elections it is clear that Eurozone countries continue to reject the nationalism and populism evident in the Brexit and US elections. France under Macron is likely to move down a path of economic reform, openness and working with Germany to strengthen the Eurozone. This is good for France, Europe and the Euro but because the French outcome had largely been factored in after the first round vote there was a bit of "selling on the fact" in the last week.

The focus now turns to the June 11 and 18 parliamentary elections in France, which are likely to see an outcome where Macron's La Republique En Marche party takes the most or maybe even a majority of seats and a centrist reformist government is supported, and then the German election in September, where Merkel is looking stronger and support for the nationalist AFD is trivial.

So, political risk in Europe has declined. It will ramp up ahead of the Italian election next year though - but even there, it’s doubtful Italy will leave the Euro. Despite the diminished political risk in Europe for now, the absence of higher underlying inflation pressures means the ECB is unlikely to back away from current supportive monetary policy settings any time soon. As ECB President Mario Draghi has pointed out, it's "too early to declare success" in lifting inflation. This is all good for Eurozone shares which should benefit from attractive relative valuations, rising economic growth and profits and a stimulatory ECB. Even Greece is looking good by the way.

The US

In the US, the political risk around the Trump Administration rose a notch with the firing of FBI director, James Comey, in the midst of the FBI's investigation into the links between Russia and the Trump presidential campaign. At this stage, this is just a political and not an economic/financial issue. But, to the extent that it adds to the risks around the GOP losing the House and Senate after next year's mid-terms and the risk of a Trump impeachment thereafter, if anything, it actually increases the pressure on the Republicans to pass healthcare and tax reform quickly. However, while these measures are not planned to require any Democrat support in the Senate, measures that do require Democrat support (e.g., Dodd Frank regulatory changes, ramped up infrastructure related spending) are looking less and less likely to pass.

Federal Budget

In Australia, the Federal Budget signalled a further shift from austerity to populism. The big positives include new spending measures being funded, retention of the target to return to surplus by 2020-21, a further ramp up in needed infrastructure spending and a more comprehensive than expected housing affordability package which may not make much short term difference but could have a big impact on a three to five year time frame if the plan to reward states for meeting housing supply targets is implemented. The negatives though include a 12-year run of budget deficits that swamp anything seen in the past (and I worry that increasingly no one seems to really care), very optimistic revenue assumptions which point to another delay in reaching the surplus target, a risk that some of the infrastructure projects will see "good debt" become "bad", a big element of tax and spend, and a populist tax on big banks, which some say begs the question of which sector might be next? 

The danger is that the focus on levy/tax hikes has opened the door to further tax increases as part of a compromise to pass the Budget through the Senate with the Opposition proposing that the 2% budget repair levy be continued for high income earners on top of a 0.5% increase in the Medicare levy, taking the top tax rate to 49.5%. The danger is that the Australian personal tax system is already highly progressive with the top 3% of taxpayers already contributing around 30% of the income tax revenue raised by Canberra. A top rate of 49.5% would be at the high end of comparable countries and compares to just 33% in New Zealand, 22% in Singapore and 15% in Hong Kong. Not great for incentive.

Major global economic events and implications

US data remains consistent with strong economic conditions with: a solid April retail sales report, continued strength in consumer sentiment, job openings, hiring and people quitting for other jobs remaining high, jobless claims remaining ultra-low, and small business optimism remaining about as strong as it’s ever been. Meanwhile, underlying consumer price inflation was weaker than expected in April and fell to 1.9% year on year after being as high as 2.3% in January. Solid economic data keeps the Fed on track to hike rates again in June and September, but soft inflation means that it will remain gradual.

A slowing in Chinese export and import growth is consistent with some recent loss of momentum in China (although prior months were a bit too strong to be believed) and slowing producer price inflation as the surge in commodity prices drops out points to a slowing in nominal growth. Chinese data continues to run hot and cold and after the heat of late last year and early this year the authorities have tapped the brakes again. However, there is little tolerance for much of a slowdown, so if things do slow too much it won't take much to shift back to the accelerator.

Australian economic events and implications

Risk of another GDP contraction in the March quarter. Australian economic data was a mixed bag, with strong readings for business confidence and ANZ job ads but a further leg down in building approvals and very soft retail sales. The peak in building approvals is now well behind us and this will show in slowing growth in dwelling construction activity this year and a contraction next year. 

Source: Bloomberg, AMP Capital

More immediately, the weakness in March quarter real retail sales (up just 0.1% quarter on quarter), coming on the back of the previous week's data showing that net exports will likely detract from growth again in the March quarter, points to the risk of a very weak and maybe even negative March quarter GDP outcome. Which, in turn, highlights downside risks to the Government's growth (and wages) assumptions. More importantly, with the Budget providing no net stimulus to the economy (in fact it’s a detraction) it still falls to the RBA to do the heavy lifting on the economy and, on this front, soft recent data and the implications for inflation make it clear that another rate cut in Australia is far more likely than a rate hike this year. With housing set to slow at a time when mining investment is still falling (albeit with a lessening impact), public investment spending and a strong contribution to growth from services exports like tourism and higher education are critically important. The latter points to the ongoing need for a lower $A - which I see falling below $US0.70 by year end.

What to watch over the next week?

In the US, expect to see the NAHB home builders’ conditions index (Monday) remain strong, April housing starts post a solid rebound after a weather affected decline in March and continued growth in industrial production (both due Tuesday). New York and Philadelphia regional manufacturing conditions surveys will also be released.

Japanese GDP growth for the March quarter (Thursday) is expected to show continued modest growth of 0.4% quarter on quarter or 1.8% year on year.

Chinese economic activity data for April to be released today is expected to show a slight softening after recent strength as tightening policies start to bring growth back into line with target. Expect to see growth in industrial production slow from 7.6% year on year to 7.1%, fixed asset investment slow to 9.1% (from 9.2%) but retail sales growth to remain at 10.9%.

In Australia, March housing finance data (Monday) is expected to show a slight gain after falling in February, the minutes from the RBA’s last board meeting (Tuesday) are likely to confirm a basically neutral bias on interest rates, March quarter wages growth is expected to be 0.5%, leaving annual growth at a record low of 1.9% year on year and consumer confidence will be watched for any boost from the Budget (both Wednesday) and April employment data (Thursday) is expected to show a 5,000 gain after a massive rise in March, with unemployment remaining around 5.9%. 

Outlook for markets

Shares remain vulnerable to a short-term setback as we come into weaker seasonal months (remember the old saving: “sell in May and go away and come back on St Legers Day”) with risks around North Korea, the latest softening in Chinese growth and commodity demand and worries ahead of the Fed’s next hike next month. 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 bonds. A resumption of the bond bear market looks to be getting underway and this is likely to see a gradual rise in yields.  

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 $US0.72 and $US0.78, 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 $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 $US0.70 by year end.

Eurozone shares gained 0.3% on Friday, but the US S&P 500 lost 0.1%. Despite the softish US lead, ASX 200 futures rose 6 points or just 0.1%, possibly helped by a higher close in iron ore prices in China, and this points to a flat to slight positive open for the Australian share market today.

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Budget preview: 3 key focus areas

Monday, May 08, 2017

By Shane Oliver

While the last week saw US shares gain 0.6% to a new record high, European shares rise 2.9% and Japanese shares gain 1.3% helped by good economic and earnings news, anticipation of a good outcome from the French election and a weaker Yen, Chinese shares lost 1.7% and Australian shares fell 1.5% on the back of signs of softer growth in China. A 10% fall in the iron ore price particularly weighed on Australian resources stocks. Bond yields mostly rose, but commodity prices fell and this weighed on the $A which looks to be breaking down again.

No surprises from the Fed

In the US, the Fed provided no real surprises describing the March quarter growth slowdown as transitory, remaining confident on the economic outlook  and still foreshadowing gradual rate hikes contingent on the economy evolving as it expects. A solid 211,000 rise in April payroll employment and a fall in unemployment to 4.4% supports the Fed’s confidence in the US growth outlook but a slight fall in wages growth to just 2.5% year on year will keep the monetary tightening process very gradual. Our view remains that the Fed is on track to hike rates again at its June meeting (with the money market factoring in a 100% probability) and again in September, and will then start allowing its balance sheet to decline later this year.

Continuing in the US, while President Trump indicated he was thinking about raising gasoline tax to fund infrastructure and break up the banks into banking and trading arms, both are unlikely with little support in Congress. Elsewhere, there was good news on the policy progress front with a government shutdown avoided (at least out to September) and the House of Representatives passing an Obamacare reform bill. The latter still has to pass the Senate but it augurs well for tax reform being passed later this year or early next.  

Major global economic events and implications

US economic data over the last week remained consistent with reasonable growth ahead. While auto sales in April were softer than expected and manufacturing conditions slowed a bit according to the ISM index, the non-manufacturing conditions ISM index rose, the trade deficit was better than expected and jobs data was solid. March quarter profits continue to impress with 78% beating on earnings, 65% beating on sales and profits up around 14% year on year.

Eurozone GDP growth was solid in the March quarter and December quarter growth was revised up with business conditions indicators pointing to a further improvement ahead. Unemployment was unchanged at 9.5% in March, which is well down from its 2013 high of 12.1%. Eurozone March quarter profits are running at up 24% year on year.

China’s official and Caixin business conditions PMIs slipped in April consistent with the view that recent policy tightening has impacted, that the upswing in growth momentum is likely over and that growth this year will be constrained around 6.5%. 

Australian economic events and implications

In Australia, the RBA left interest rates on hold and its Statement on Monetary Policy made no significant changes to its economic forecasts, but it’s more confident that its forecasts for stronger growth and inflation are on track. With the economy growing, headline inflation back within the RBA’s 2-3% target zone and concerns remaining around the Sydney and Melbourne property markets, the pressure to cut rates again has declined. But by the same token it’s too early for the RBA to think about raising rates given continuing low underlying inflation pressure, very high underemployment, record low wages growth, risks to growth from weaker than expected trade volumes and a still too high $A.

Signs that Sydney and Melbourne property markets may be starting to cool – thanks to bank rate hikes, tightening lending conditions, all the talk about a property bubble and rising unit supply – will, if continued, add to the RBA’s flexibility on rates. While RBA Governor Lowe has stated that “over time we could expect interest rates to rise” this is really just a statement of the obvious. Our base case remains that the RBA will be on hold out to the second half of 2018 when rates will start to rise. 

On household debt and house prices, Governor Lowe provided a good analysis of the RBA’s concerns about why high household debt to income ratios leave the economy vulnerable – the risk being that at some point households decide that they have borrowed too much and that they should reduce their debt levels which would adversely affect spending and hence magnify any economic impact from a shock to income or house prices. This is a valid concern and our view remains that the intersection of high house prices and household debt are Australia’s Achilles heel. As always, it’s hard to see the trigger for such a shock but the ideal outcome remains an extended period of flat/range bound home prices allowing incomes to catch up. Governor Lowe also pointed out that the RBA will take account of the likely greater responsiveness of consumer spending to interest rate hikes – expect the next interest rate tightening cycle to be even more gradual and modest than those of the past.

In terms of the housing market, while auction clearance rates remains very strong, CoreLogic home price data showed a slowing in Sydney and Melbourne in April with falling prices for units suggesting that these two property markets may be starting to cool. It’s too early to get too excited though, given the impact of school holidays, Easter and Anzac in April. Meanwhile, the AIG’s manufacturing and services conditions PMIs for April were strong pointing to solid economic growth but the trade surplus fell in March thanks to stronger imports and the impact of Cyclone Debbie on coal exports which will be more noticeable in April. Expect another growth detraction from net exports in the March quarter resulting in a weak GDP growth outcome.

What to watch over the next week?

The outcome of the French election will likely dominate early in the week. In the US, expect small business confidence to pull back a bit and continued strength in labour market indicators (both Tuesday), a bounce back in consumer price inflation but with the annual core rate remaining around 2% and strong gains in April retail sales (both Friday).

Chinese trade data is expected to show slightly slower but still strong export and import growth (Monday) of 10% and 15% respectively, consumer price inflation (Wednesday) is likely to rise to 1.1% year on year but producer price inflation should fall back to 6.8% as commodity price momentum wanes.

In Australia, the main focus will be on the 2017-18 Federal Budget on Tuesday. This Budget won’t have the divisive austerity focus of the 2014-15 budget, nor the pre-election and superannuation focus of last year’s Budget. The attention is likely to be on three areas: the Budget deficit projections, a ramp up in infrastructure spending and housing affordability. 

Budget deficit projections

First, after years of Budget blow outs thanks to optimistic economic assumptions, spending blow outs and a failure to pass budget savings, this Budget could see a slight improvement in the deficit projections relative to December’s mid-year review. While low wages growth is dragging on personal tax collections, higher corporate tax collections thanks mainly to higher iron ore and coal prices, will likely provide some offset. The Budget is likely to forecast 2017-18 real GDP growth of 3%, nominal GDP growth of 4% and unemployment of 5.5%. We expect the 2017-18 deficit projection to come in around $27bn (compared to $28.7bn in MYEFO) and that for 2018-19 to be around $19bn (compared to $19.7bn in MYEFO) with the return to surplus remaining in 2020-21. This should preserve Australia’s AAA credit rating, at least for now.

Source: Commonwealth Budgets, AMP Capital

That said, we are still looking at a run of 12 years of budget deficits which swamps the seven years seen in the 1990s and the five years in the 1980s. And this is quite an achievement given that we haven’t had the deep recessions of the early 1980s and 1990s! Rather, we have done this thanks largely to a combination of politicians ramping up spending commitments on a whole range of things without facing up to how they will be paid for. And we continue to rely inordinately on assuming the best to drive revenue up rather than taking hard decisions to limit spending growth. 

Infrastructure spending 

Secondly, the Budget is likely to see a huge emphasis on infrastructure spending focussed on building the second Sydney airport, along with various rail and road projects mostly using public companies backed by debt. The Government’s differentiation between “bad debt” used to fund current spending and “good debt” used to fund capital works will likely clear the way and like the NBN Co this debt won’t show up in the budget accounts.

It makes sense to mainly use debt for spending on assets that have a long-term life and the productivity enhancing potential of more infrastructure spending has much merit and can actually “crowd in” private investment. The big downside though is that the good and bad debt differentiation does nothing on its own to wind back “bad debt” and that some of the projects may turn out to be white elephants that ultimately have to be written down (like some say should occur with the NBN) in which case the debt will come back into the Budget. It’s also unclear how real the ramp up in infrastructure spending will really be – last year’s Budget touted a $50bn infrastructure spend until 2020 – will this year’s infrastructure reboot be a repackaging of that, or additional net spending?

Housing affordability 

Thirdly, the Budget is likely to contain a number of measures designed to help improve housing affordability. The key elements are likely to be allowing first home buyers to save for a deposit out of pre-tax income, allowing retirees who downsize the family home to exceed the new $1.6m limit on superannuation, encouraging the supply of low-cost community housing by allowing providers access to lower cost public debt (the so-called bond aggregator) and maybe imposing a nationwide vacant property tax. These things may help but only at the margin given the Governments decision not to wind back the capital gains tax discount and more importantly, its inability to do much about boosting the supply of housing because that’s largely a state’s issue.

The Budget will likely also confirm that the yet to be passed welfare and higher education (“zombie”) savings from the 2014 Budget will be dropped. With the Government already announcing a new plan for higher university fees and reduced university funding that will help offset increased school funding (Gonski 2.0), this still means new savings of around $10bn over four years will be needed to offset the dropped “zombie” savings. So, expect some new welfare cuts and revenue measures with the latter possibly involving an extension of the Medicare levy surcharge.

On the superannuation front, apart from the measures to encourage downsizing, the main focus is now on bedding down the changes enacted over the last year, so with a little luck it should be a super lite budget.

On the data front in Australia, expect a 4% fall back in March building approvals (Monday) but a 0.3% bounce in March retail sales (Tuesday) with a 0.7% gain in March quarter retail sales volumes. Business conditions according to the NAB survey (Monday) are likely to remain solid and May consumer confidence (Wednesday) is expected to remain just below average.

Outlook for markets

Shares remain vulnerable to a short-term setback as we come into weaker seasonal months (remember the old saving “sell in May and go away and come back on St Legers Day”) with risks around North Korea, the latest softening in Chinese growth and commodity demand and worries ahead of the Fed’s next hike next month. 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 bonds. A resumption of the bond bear market looks to be getting underway and this is likely to see a gradual rise in yields.  

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 $US0.72 and $US0.78, but our view remains that the downtrend in the $A from 2011 is likely to resume this year. The rebound in the $A from the low early last year of near $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 $US0.70 by year end.

Eurozone shares rose 0.8% on Friday and the US S&P 500 gained 0.4% to a record high helped along by good jobs data. The positive global lead saw ASX 200 futures rise 55 points or 0.9% pointing to a strong open for the Australian share market on Monday morning.

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'Risk on' thanks to France and Trump's tax plan

Monday, May 01, 2017

By Shane Oliver

The past week saw “risk on” following the outcome of the first round of the French election and in anticipation of President Trump’s tax plan. Mostly good economic and earnings news helped too. This saw US shares up 1.5% for the week, Eurozone shares up 3.4%, Japanese shares rise 3.1% and Australian shares gain 1.8%, but Chinese shares dipped 0.8% on news of tighter financial regulation. Reflecting the ''risk on'' tone bond yields rose in core countries (but fell sharply in France), but commodity prices were mixed and the $A fell.

There has been a lot of action on the policy front in the US over the last week – most of which has been positive:

President Trump's much anticipated tax plan provided few surprises: a reduction in the corporate tax rate to 15% (from 35%); a one-off tax on repatriated cash earnings (of 10%); no border adjustment tax (it’s just too hard); collapsing the personal tax brackets from seven to just three of 12%, 25% and 33% (with the current top bracket being 39.6%); doubling the tax free threshold to $US24,000; and cutting itemised deductions. While it was short on details, this is to be expected as it is really just an opening statement of principles with agreement to be reached with Republicans in Congress who have their own plans that head in the same direction, i.e. lower rates. So compromise is likely - probably resulting in a corporate tax rate of 20% rather than 15%. If the package is “revenue neutral” after 10 years - helped by savings from Obamacare reform, less deductions and "dynamic scoring" which takes account of a possible growth dividend then it should pass Congress with just a simple majority in the Senate (which the Republicans’ have). But, if it’s not revenue neutral, 8 Democrat senators will be needed to support it and that’s a big ask - so expect it to be "revenue neutral", although that still means a boost to growth. There is a long way to go yet so tax reform may not make it into law until early next year. But what the plan shows is that tax reform remains high on the President's agenda and this is all that matters for markets.

Trade got back in headlines over the last week, with the US imposing countervailing tariffs on Canadian softwood, investigating imports in relation to the steel and aluminium industries and talk of withdrawing from NAFTA. However, tariffs were deployed under Bush and Obama at times and Trump denied a withdrawal from NAFTA in favour of renegotiation. All of which sounds like bargaining noise. But we remain a long way from the trade war many fear. 

A US Government shutdown looks unlikely – with Congress agreeing on funding for a week and close to reaching a longer term funding agreement.

Of course, risks remain high around North Korea as it test fired another missile (which looks to have failed), although Trump indicated he prefers a diplomatic solution.

The French election

The first round of the French election saw a good result for markets (and France) with the centrist Macron wining 24% of the vote and the far-right anti Euro Le Pen on 21.3% to now face each other in the run-off election on May 7. Macron’s relatively complacent post-election speech and team dinner in an up market restaurant did not get his round two campaign off to a strong start with Le Pen’s side playing up his establishment credentials. A portion of those who voted for centre-right Fillon and far-left Melenchon may also transfer their support to Le Pen and some 20-30% of voters may abstain. More terrorist attacks may also boost support for Le Pen. So, a Le Pen victory is still possible. If this were to occur, French citizens and investors would fear she will find a way out of the Euro even though there are immense barriers to such a move and this would likely see runs on French banks (remember Greece in 2015), a surge in French bond yields relative to German yields and a renewed bout of Eurozone break up fears weighing particularly on the Euro and Eurozone shares but also on global shares as was the case at the height of the Eurozone crisis in 2011-13. However, against this, Macron has a solid poll lead of around 20% against Le Pen which is far wider than the 4% poll error seen in the Brexit vote and the 2% poll error seen in the US election. This is narrowing a bit – which may be a good thing in order to stop complacency sinking in - but our base case is that with the majority of the French wanting to stay in the Euro and negative towards the far right National Front that Le Pen represents Macron will ultimately win on May 7. Expect some nervousness along the way though. 

Major global economic events and implications

US data was mostly good with a gradual rising trend in capital goods spending orders, solid home sales, continuing gains in home prices and still high consumer confidence. Meanwhile, March quarter profits continue to surprise on the upside. We have now seen 58% of companies report with 81% beating on earnings and 65% beating on sales. Earnings are up 12% year on year and on track for the fourth quarterly gain to new record highs. While March quarter GDP growth slowed to just 0.7% annualised, this appears to reflect a seasonal distortion that will reverse in the June quarter. Over the last 20 years March quarter growth has been about 1% weaker than the other quarters and has been followed by a June quarter rebound. Solid business conditions readings, strong profit growth and ultra low jobless claims also indicate underlying growth is much stronger and the 1% March quarter growth detraction from inventories won’t be repeated. 

As expected, the ECB made no changes to monetary policy with President Draghi more upbeat on growth but remaining relatively dovish on the back of weak core inflation. Meanwhile, April confidence readings in the Eurozone pushed up to the highest levels since before the GFC. While inflation bounced in April this was largely due to a seasonal distortion due to Easter.

The Bank of Japan also remained on hold consistent with its commitment to continue quantitative easing and zero bond yields until inflation exceeds 2%. Given core inflation fell to -0.1% yoy in March this will be the case for a long time. 

Australian economic events and implications

In Australia, headline inflation rose to 2.1% year on year in the March quarter putting it back in the RBA’s 2-3% target range. This is good news to the extent it signals that the risk of deflation has receded. But it’s too early to get excited. The cost of living is now rising faster than wages and this will act as a drag on household spending. And abstracting from higher petrol prices and increases in prices for government influenced items like utilities, health and education underlying inflation in the market sector of the economy remains too low at just 1% year on year. 

In other data, producer price inflation remains soft, skilled vacancies fell for the second month in a row, which is a bit of a concern, credit growth remained weak with lending to property investors slowing but a surge in export prices in the March quarter points to another rise in Australia’s terms of trade.

Meanwhile, with the Federal Budget close, two things are worth highlighting. First, the Government is playing down what it can deliver on housing affordability – maybe a few fiddles to encourage downsizing but since the big issue is supply and that is a state issue there is not really much it can do. Second, its new-found focus on distinguishing between “good” debt (where debt is used to finance investment in assets like infrastructure that have a long term payoff) and “bad” debt (where debt is used to finance current spending) makes some sense. There is logic in using debt mainly for assets as it spreads the cost of paying for them to future generations who will benefit from them and such an approach may help reinvigorate the focus on getting current spending under control. The danger though is that it just results in a smoke and mirrors trick that allows a further ramp up in debt with no real slowing in recurrent spending. Ratings agencies would just see through that and such an approach did not help the WA Government. That said, it does look like there will be a ramp up in debt financed infrastructure spending in the coming budget.

What to watch over the next week?

In the US, the Fed (Wednesday) is expected to make no changes to monetary policy but signal ongoing confidence in the US outlook and that a gradual normalisation of monetary policy remains appropriate consistent with another rate hike in June and a start to letting its balance sheet decline later this year. Meanwhile, expect the April ISM business conditions indexes (Monday and Wednesday) to remain strong at around 56, the core consumption deflator for March (Monday) to fall to 1.6% year on year and March employment growth to bounce back to a solid 195,000 but wages growth to remain at 2.7% year on year. US March quarter earnings will continue to flow.

In the Eurozone, expect unemployment (Tuesday) for March to fall to 9.4% from 9.5% and March quarter GDP growth (Wednesday) is expected to rise 0.6% quarter on quarter or 1.8% year on year.

China’s Caixin manufacturing conditions PMI (Tuesday) is expected to rise slightly to 51.4.

In Australia, the Reserve Bank (Tuesday) is expected to leave the cash rate on hold at 1.5% for the ninth month in a row. The rise in headline inflation to back within the RBA’s 2-3% target zone has reduced the pressure to cut rates again at a time when the RBA would rather not cut any way given worries about the Sydney and Melbourne property markets, but continuing low underlying inflation pressure at a time of very high underemployment, record low wages growth and a still too high $A means that its way too early to be thinking about raising rates. Our base case remains that the RBA will be on hold out to the second half of 2018 when rates will start to rise. The RBA’s quarterly Statement on Monetary Policy (Friday) is unlikely to make any significant changes to its forecasts. On the data front, expect CoreLogic data (Monday) to show a stalling in home price growth in April possibly reflecting softer investor demand on the back of higher bank rates, tighter lending standards and all the bubble talk. The March trade surplus (Thursday) is likely to have fallen.

Outlook for markets

Shares remain vulnerable to short term setbacks particularly given the risks around North Korea and the final round of the French election. But 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. 

Low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds. A resumption of the bond bear market looks to be getting underway and this is likely to see a gradual rise in yields.  

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 $US0.72 and $US0.78, but at some point this year 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), as the Fed eventually moves to reduce its balance sheet and hence narrow measures of US money supply and as the iron ore price remains down from its February highs.  

Eurozone shares fell 0.1% on Friday and the US S&P 500 lost 0.2%. As a result of the soft global lead ASX futures fell 0.1% pointing to an 8 point decline for the ASX 200 when it opens on Monday morning.

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Macron to face Le Pen: A good outcome for investment markets

Monday, April 24, 2017

By Shane Oliver

As suggested by opinion polls, the centrist pro-Euro candidate Emmanuel Macron will face far right anti-Euro National Front candidate, Marine Le Pen, in the May 7 run-off vote for President of France. 

With around 80% of the vote counted, Macron is on track to take 23.4% of the vote, with Le Pen on 22.6%, centre-right Francois Fillon on 19.9% and far-left Jean-Luc Melenchon on 18.9%. This is pretty much in line with recent polls and along with the Netherlands election, provides a vindication of them. 

This result is positive for investment markets, with the Euro up around 1.5% from Fridays close, as in recent weeks there was a fear that Melenchon would make the run off against Le Pen as both advocate policies that would threaten the Euro (albeit Melenchon a bit less so) and would be negative for the French economy (increasing state participation in the economy, deficit spending, more regulation, etc).

With all the talk about a populist/nationalist surge across Europe, supposedly on the back of the Eurozone public debt and migration crises, the Brexit and Trump wins, and Thursday's latest terrorist attack in France, the surprise for many may have been that Le Pen did not do better. In fact, poll support for her looks to have peaked at the tail end of the Eurozone crisis in 2013 when it got as high as 35%. 

Support for nationalists in Europe has been wildly exaggerated and the first round of the French poll marks the fourth election since Brexit - Spain, Austria, the Netherlands and now France - that has seen the nationalists do less well than expected. The majority of the French support remaining in the Euro and this works against nationalist extremists as was shown a few years ago in Greece where Syriza only attained power after dropping its anti-Euro policies and is now just another centrist European party. Perhaps also the Europeans have seen Brexit and the US election outcome and decided that’s not for them.

However, the French election won't be over until May 7. Macron's policies seek to strengthen the European Union, maintain openness and are mildly reformist for France - which would be good for the Euro and the French economy. However, Le Pen wants to re-establish the Franc for domestic transactions and allow the Bank of France to print money to finance deficit spending. Whilst her National Front won't win control of the National Assembly (parliament) in June elections, and so the new French Government will not implement many of her policies and a referendum to exit the EU and Euro is unlikely to pass given majority support to remain in the Euro, this won't stop French citizens and investors generally, from fearing that she will find a way to exit the Euro if she wins the presidency in the May 7 run-off. So, a Le Pen victory would likely see runs on banks (remember Greece in 2015), a surge in French bond yields relative to German yields and a renewed bout of Eurozone break up fears weighing particularly on the Euro and Eurozone shares but also on global shares as was the case back at the height of the Eurozone crisis in 2011-13.

Fortunately, Macron has been consistently ahead of Le Pen in polling for a second round run-off with the gap on the latest poll average well above 20%. This is far wider than the roughly 4 point polling error in the Brexit result and the 2 point polling error in the Trump-Clinton vote in the US Presidential election.

Source: Bloomberg, AMP Capital

That said, there is still a risk that things could go wrong and lead to a surprise Le Pen victory. A spate of IS terrorist attacks could drive support towards Le Pen (they are likely on Le Pen's side given that they thrive on extremism) or Russia could release hacked information damaging to Macron (via Wikileaks). And while it’s hard to see supporters of Melenchon or the Socialist Hamon supporting Le Pen, some of Fillon's centre-right supporters may switch to Le Pen rather than Macron. Fillon’s endorsement of Macron for the run-off may help minimise this though. Hamon has also endorsed Macron.

Moreover, with a majority of the French in favour of the Euro and highly negative to the far right National Front (partly for historical reasons) and the polling gap in favour of Macron in excess of 20% which is well beyond the standard error, our base case remains that Macron will win on May 7.

This would be a big positive for Eurozone assets. It would reinforce the impression that the populists are not winning in Europe. While some see the German election in September as a threat this is very unlikely as the contest looks to be between Angela Merkel and the Social Democrats under Martin Schulz who are even more pro Europe, with the nationalist Alternative for Deutschland polling very poorly. This, in turn, should help reduce Eurozone break up fears. While Italy remains a risk for next year, this all comes at a time when Eurozone assets are relatively cheap globally and Eurozone economic data continues to improve. All of which is consistent with retaining a large exposure to Eurozone shares. 

Source: Bloomberg, AMP Capital

For Australia, the outcome of the first round of the French election is unlikely to have a major impact beyond keeping in place the currently favourable global growth backdrop. That said, there is likely to be a mild relief rally in the Australian share market today and the $A has already had a 0.4% bounce against the $US reflecting its “risk on” status.

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Weekly economic and market update

Monday, April 10, 2017

By Shane Oliver 

Share markets were mixed over the last week, with ongoing nervousness regarding whether US President Donald 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.

US missile strike

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 Trump as some feared - and that is a good thing.

Trump's tax agenda

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 could 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 Jinping 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 Trump’s pro-business agenda remains the focus, investment markets won’t be too fussed.

US Fed signals balance sheet reduction

The US Federal Reserve signals that the third phase of monetary policy normalisation – i.e. 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 commences 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 French election

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

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 four-five years are a guide to the future, it's 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% year-on-year, 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 it's 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% year-on-year 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% year-on-year (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% year-on-year but a pick-up in export growth to 10% year-on-year. 

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 6,000.

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 $US0.72 and $US0.78 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.

Eurozone shares rose 0.2% and the US S&P 500 slipped 0.1% on Friday as investors digested the messy US jobs report (weak headline payrolls but strong details) and the missile attack on Syria. However, the impact on global share markets from the Syrian missile strike was less than the Australian share market had factored in on Friday (where a 0.5% gain in the market was largely wiped out by news of the attack). As a result, ASX 200 futures gained 14 points or 0.2% pointing to a positive start to trade for the Australian share market on Monday.

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Will APRA's move cool Sydney and Melbourne property?

Monday, April 03, 2017

By Shane Oliver

Stronger global economic data dominated the action over the last week, offsetting some of the fears around whether President Trump will be able to pass his pro-business policies through Congress. So while Japanese shares fell 1.8% and Chinese shares lost 1%, US shares rose 0.8%. Eurozone shares gained 1.6% and Australian shares rose 1.9%. Commodity prices mostly rose and the $A rose slightly. Bond yields mostly fell.

UK starts divorce proceedings

The UK has finally lodged its notification to the European Union to formally start up to two years of divorce proceedings. Ho hum! It’s been talked about for so long that markets barely reacted. There will be a long way to go, with lots of noise. The European Union will be a tough negotiator as membership of it brings benefits and obligations, so there is a high risk of a hard Brexit. Just remember though that the UK is only 2.5% of global GDP and there has been no evidence that the Brexit vote will lead to a domino effect of other countries looking to exit as well (in fact, the three Eurozone elections since Brexit have seen less support for anti-Europe populists). So there is no need for investors to get excited about it.

Trump-land troubles

The US Congress will likely remain an ongoing source of noise for investors, but what’s new? While the failure of the Obamacare reforms has led to a quick shift to focussing on tax reform, negotiations among House Republicans around a passable health care bill appear to be continuing, so it’s not dead in the water. Talk of another government shutdown will also likely start to escalate through April as a new continuing resolution funding spending will need to be passed by April 28th. Ongoing dysfunction in Congress means that a shutdown is possible but as the 2013 experience showed, it’s not in either the Republican’s or Democrat’s interest to be seen as the cause. So our base case (70% probability) is that a deal will be worked out when required. And then, of course, around July to September the debt ceiling will need to be raised again or further suspended which might bring us back to the old “will the US government default?” debate. Again, our view is that this will be solved too but it could go down to the wire. All up, this is really just more of the same, but as long as Trump gets something through at least on tax cuts, share markets should be reasonably happy. Meanwhile, he is continuing to wind back business regulation with the latest being the lifting of a number of restrictions on energy companies and with the Administration signalling mostly modest changes to NAFTA in relation to Mexico; the Mexican Peso is up 15% from its January low.

APRA's move

APRA’s long awaited additional macro prudential tightening adds to the likelihood that the Sydney and Melbourne property markets will start to slow. The main change from APRA was an expectation that lenders limit interest-only loans to 30% of new mortgage lending (from around 40% at present), strict limits on loan-to-value ratios above 80% for interest-only loans, along with an expectation that lending to investors remains "comfortably below" the 10% growth limit, that serviceability measures remain "appropriate" and that lending to high-risk categories is “constrained”. 

Source: APRA, AMP Capital

That APRA moved again was no surprise (they should have done something last year!), but the main surprise was that the investor lending speed limit remains at 10% rather than being cut to a more reasonable 5-7%. Limiting interest-only lending may have the same effect as cutting the speed limit because around 60% or more of investor loans are interest only, but time will tell, so further action may be required.

Putting that uncertainty aside though, the latest moves by APRA, coming on the back of bank mortgage rate hikes over the last two weeks, the likelihood of action to boost affordability in the May budget (including a cut to the capital gains tax discount) and the surge in unit supply at a time of silly prices, are all likely to result in a slowdown in property price gains in Sydney and Melbourne this year ahead of a 5-10% price fall starting next year some time. In the short term, all eyes will be on Saturday's auction clearance rates to see whether there is much headline impact from APRA’s moves!

Impacts of Cyclone Debbie

Our thoughts are with those affected by Cyclone Debbie along Australia’s north east coast. While it’s too early to know the full extent of the damage, economic disruption (to crops, tourism, mining activity, etc) could knock 0.1 to 0.2% off GDP growth spread across the March and June quarters (but mainly the latter) and a boost to headline inflation via higher fruit and vegetable prices in the June quarter is likely as the area is a major supplier of bananas, tomatoes, etc. The RBA will tend to look through these effects as they will be temporary.  

Major global economic events and implications

US data over the last week was mostly strong, with consumer confidence at is highest since 2000, home prices continuing to rise, pending home sales up strongly, jobless claims remaining low, December quarter GDP growth being revised up and the goods trade deficit narrowing. Against this though personal spending remained weak in February. Core personal consumption deflator inflation rose to 1.8% year-on-year continuing to edge towards the Fed’s 2% target.

Eurozone sentiment readings were strong, with economic sentiment about as high as it ever gets and strong readings for the German IFO business conditions index. Against this, Eurozone bank lending data was weaker than expected in February and core inflation fell to 0.7% year-on-year which looks temporary but still highlights inflationary pressures are very low. 

Japanese data for February was mixed with strong industrial production and labour market data, but household spending remaining weak and core inflation stuck around zero.

China’s business conditions PMIs rose in March indicating growth continues to edge up. It’s increasingly looking like the growth up tick is broadening out beyond the initial impact of last year’s policy stimulus, in particular into private sector services companies. It’s consistent with policy makers continuing to tap the brakes (with more cities imposing housing curbs).

Australian economic events and implications

In Australia, new home sales showed a continued gradual downtrend, job vacancies remained solid and private credit growth slowed further led by weak business lending. Of most interest in the credit data was a pickup in lending to property investors to 6.7% year on year and over the three months to February it grew at annualised pace of 8.3% compared to just 4.3% a year ago. No wonder the regulators are looking to ensure it does not continue to accelerate. 

What to watch over the next week?

In the US, expect the March ISM manufacturing and non-manufacturing conditions indexes (Monday and Wednesday) to remain strong and jobs data (Friday) to show solid payroll growth of 175,000 with unemployment unchanged at 4.7% but wages growth stuck at 2.8% year on year. Trade data (Tuesday) is likely to show a reduced deficit. The US data flow in the week ahead, along with the minutes from the last Fed meeting (Wednesday), will likely to do nothing to alter expectations for another two or three Fed rate hikes this year. A vote on Neil Gorsuch’s nomination to the Supreme Court will be watched closely as a guide to future Republican/Democrat “cooperation” and the summit between Trump and China’s President will be watched to see how trade tensions evolve.

The Japanese Tankan business survey (Monday) is likely to show a further improvement in business confidence.

RBA expected to leave rates on hold

In Australia, the RBA is expected to leave rates on hold at 1.5% for the eighth month in a row when it meets on Tuesday. A rate cut is unlikely because economic growth has bounced back after its September quarter slump, the RBA expects that underlying inflation has bottomed and will gradually rise and the Sydney and Melbourne property markets are uncomfortably hot, posing financial stability risks. By the same token it's way too early to be thinking about rate hikes as underlying inflation risks staying below target for longer, the $A is too high, unemployment and underemployment at over 14% combined are way too high and out-of-cycle bank mortgage rate hikes have delivered a de facto monetary tightening any way.

The RBA has to set interest rates for the average of Australia, so raising interest rates just to slow the hot Sydney and Melbourne property markets would be complete madness at a time when growth is still fragile and underlying inflation well below target. The best way to deal with the hot Sydney and Melbourne property markets and excessive growth in property investor lending into those markets is through tightening macro prudential standards, which APRA has again moved to do. 

On the data front in Australia, expect to see a 0.2% gain in February retail sales, a 0.5% rise in building approvals and continued strength in home prices in March according to CoreLogic led by Sydney and Melbourne (all due for release Monday) and a continued trade surplus (Tuesday). The AIG’s business conditions PMIs will also be released. 

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 opportunities to “buy the dips”. Shares are likely to continue 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 to around 3-4% this year, 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 $US0.72 and $US0.78 and this may continue for some time yet. 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 3 or 4 times and the RBA remains on hold).

Eurozone shares gained 0.6% on Friday but the US S&P 500 fell 0.2%. Despite the softish lead from the US share market, ASX 200 futures rose 7 points or 0.1% pointing to a flat to slightly positive start for the Australian share market on Monday morning.

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Trump's pro-business agenda remains on track

Monday, March 27, 2017

By Shane Oliver

Investment markets and key developments over the past week

The US share market finally saw a daily decline greater than 1% for the first time since last October and this dragged other share markets down to greater or lesser degrees over the last week. Chinese shares rose 1.3% over the week, but US shares fell 1.4%, Eurozone shares fell 0.2%, Japanese shares lost 1.7% and Australian shares fell 0.8%. Worries about whether President Trump will be able to pass his pro-business agenda of tax cuts, deregulation and infrastructure spending were the main drivers but high levels of short term investor optimism have left the market vulnerable. The risk off tone in markets saw government bond yields decline, credit spreads widen and commodities excepting gold weaken. The $US also fell, but this didn't stop a decline in the $A.

Will Trump's pro-business agenda pass Congress after the vote on a replacement for the Affordable Care Act (or Obamacare) was pulled? Can the Republicans get their act together? A common concern seems to be that if Trump and the Republicans can't pass their Affordable Care Act (or Obamacare) replacement, what hope have they got for the bigger measures around tax cuts, etc.? This reasoning is too simplistic. Obamacare had three key elements: Federal spending on healthcare subsidies; tax hikes to pay for them; and regulations imposed on health insurers. The Republican House leadership reasoned that if they reverse the spending increase and tax hikes then their Obamacare reform could pass through the Senate as part of the budget reconciliation process which just requires 51 votes (out of 100 Senators) which they have rather than the normal 60 votes (which they don’t have) if they push for removal of regulations as well. The sticking point was that the Freedom Caucus (a group of conservative tea party sympathetic Republicans in the House) wanted to remove the regulations too which would mean that any bill that passes in the House probably wouldn’t pass in the Senate. So the decision was taken that it’s all too hard and so the vote was pulled. This is good because it was just a distraction.

But a failure of the Obamacare reform does not mean that Trump’s pro-business reforms will be stalled. The Freedom Caucus, the broader Republican Party in Congress and Trump all want lower taxes and less regulation and would prioritise this as they want to “starve the beast” of government as they see it. The GOP also realise that given the risks around Trump's presidency (investigations around links to Russia, risk of eventual impeachment) and the risk they lose the Senate in next year's mid-terms mean that they only have a small window to get through the reforms they want. So they are not going to let the failure (so far) to repeal Obamacare get in the way of their small government agenda. The bottom line is that Trump’s pro-business agenda remains on track. Out of interest, note that on Friday Trump formally approved the Keystone XL pipeline, his third energy infrastructure project to be approved. 

The tragic events in London perpetrated by another deranged nutcase provide another reminder of the ongoing terrorist threat. But as has been the case with recent terrorist attacks the impact on investment markets was minor as investors have become accustomed to them (much as occurred a generation or so ago with the IRA and other terror attacks in Europe) and their economic impact remains insignificant.

In Australia, signs continue to point to an imminent fresh round of macro prudential controls to slow lending to property investors and further tighten home lending standards. The minutes from the RBA’s last Board meeting clearly indicate that it has become more concerned about a “build-up of risks associated with the housing market” and there is reportedly a special regulatory working group – composed of the RBA, APRA and ASIC – looking at the issue. Likely measures include a cut in the cap on annual growth in the stock of investor lending to 5-7% from 10% now (it’s been running at 8.5% lately) and tougher interest rate tests for borrowers. In fact, with out of cycle bank mortgage rate hikes heavily skewed to property investors (at around +25 basis points) as opposed to owner occupiers (at around +3 basis points) it’s clear that the regulators have already increased the pressure on banks to slow lending to investors. The last round of macro prudential measures combined with significant negative media publicity at the time worked very well in late 2015/early 2016 in slowing the Sydney and Melbourne property markets and would have kept working if they were tightened again around six months ago when it became clear that the initial impact was wearing off. Sure macro pru is second best to using rate hikes to slow property prices, but in the absence of more fundamental solutions it’s the best option at a time when its way too early to hike rates given the state of the overall economy and property markets outside of Sydney and Melbourne.

While strong population growth means that underlying property demand remains strong, the threats to the hot Sydney and Melbourne property markets are continuing to build: another round of macro-prudential measures looks on the way with regulators already putting pressure on banks to slow lending to property investors; the banks are raising rates out of cycle particularly for investors (with the CBA and ANZ joining the NAB and Westpac in hiking in the last week); the Federal, NSW and Victorian governments are swinging into gear to improve housing affordability; all at a time when the supply of units is surging; and prices are ridiculous. Expect a significant cooling in price growth in Sydney and Melbourne this year followed by 5-10% price falls commencing sometime in 2018.

Major global economic events and implications

US data was mostly good. Existing home sales and home prices were weaker than expected but durable goods orders were strong, new home sales surged, jobless claims remain historically low and while the manufacturing PMI fell it remains solid.

Eurozone business conditions PMIs rose more than expected in March to strong levels and point to a pickup in growth. Consumer confidence rose and is about as high as it ever gets. Europe is looking good for investors as growth looks set to pick up and this will boost profits, the ECB remains very supportive and Eurozone shares are relatively cheap in part due to overstated fears of a break-up of the Eurozone.

Japan’s manufacturing conditions PMI slipped in March but remains in a rising trend and continues to point to reasonable economic growth.

Australian economic events and implications

In Australia, official ABS home price data confirmed that the housing market has hotted up again after a soft patch in late 2015-16. Private data points to a further acceleration in the first few months of this year. Sydney and Melbourne remain the main culprits though with prices still trending down in Perth and Darwin and only seeing moderate growth in other cities. Meanwhile, September quarter data showed an uptick in population growth to a solid 1.5% year on year or 349,000 people highlighting a key source of underlying property demand.

What to watch over the next week?

In the US, no doubt the debate around the failure to reform Obamacare will remain a focus. But in our view it was just a silly distraction and President Trump and Congressional Republicans will just move on to the key elements of his pro-business agenda, notably tax cuts. On the data front, expect to see consumer confidence remaining high and continued growth in home prices (both Tuesday), a bounce back in pending home sales (Wednesday), modest growth in personal spending and core consumption deflator inflation remaining around 1.7% for the 12 months to February (Friday).

Eurozone economic confidence indicators (Thursday) are expected to remain solid and core inflation is likely to have remained unchanged at 0.9% year on year in March.

Japanese data for February to be released Friday is likely to show continued strength in the labour market, strong industrial production but weak household spending and core inflation remaining only just above zero.

The UK will likely trigger Article 50 of the Lisbon Treaty on Wednesday setting off a two year negotiation process to exit the EU. There will be a long way to go but the EU is likely to be a tough negotiator.

China’s manufacturing conditions index for March (Friday) is expected to slip back to 51.5 but retain most of its recent gains.

In Australia, expect credit growth (Friday) to remain moderate but the focus will likely be on a further acceleration in lending to property investors. Data on new home sales and job vacancies will also be released.

Outlook for markets

Shares remain vulnerable to a short term pull back of around 5% 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 as the uncertainty around Trump’s pro-business agenda showed over the last week. However, we would see any pullback as an opportunity to “buy the dips” as valuations are okay, global monetary conditions remain easy and global profits are accelerating on the back of stronger global growth. So shares are likely to continue to trend higher on a 6-12 month horizon.

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 to around 3-4% this year, 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 $US0.72 and $US0.78 and this may continue for some time yet. 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 3 or 4 times and the RBA remains on hold).

Eurozone shares were flat on Friday and the US S&P 500 lost 0.1%. US shares had a bit of a roller coaster session - initially rising 0.4%, then falling 0.4% as the vote on replacing Obamacare was pulled only to end little changed as the focus moved on to tax reform. Reflecting the basically flat global lead ASX futures rose just 1 point (or 0.02%) on Friday night pointing to a basically flat open for the Australian share market on Monday morning.

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5 reasons why the RBA won't raise rates this year

Monday, March 20, 2017

By Shane Oliver

Global shares got a boost over the last week from a dovish rate hike from the Fed and relief that the Dutch election saw a rejection of far-right Eurosceptics. US shares gained 0.2%, Eurozone shares rose 1.2% and Chinese shares rose 0.5%. Reflecting the positive global lead, resources shares helped drive Australian shares 0.4% higher. Japanese shares slipped 0.4% though as the Yen rose. The Fed’s dovish hike also saw bond yields and the $US decline, which in turn helped commodity prices, emerging market shares and the $A.

The Netherlands election

The Netherlands election highlights, yet again, that the risk of a Eurozone break up is exaggerated, with Dutch voters turning out in large numbers to support pro-Euro parties. PM Mark Rutte’s Liberal Party won 33 seats in the 150 seat lower house of parliament against Geert Wilders’ Eurosceptic Freedom party which only received 20 (or just 13% of the vote). The Liberal Party will lead negotiations to form a centrist coalition government (which usually takes months) and Rutte will most likely remain PM. This is a blow to the Freedom party, which only a few weeks ago looked like it could get more votes than any other party. It’s the third election in the Eurozone in a row since Brexit – Spain, Austria and now the Netherlands – that has seen anti-Euro populists bomb out. The Europeans look to have seen Brexit and Trump and decided that’s not for them! Popular support for the Euro remains high and this is clearly working against populist/nationalist parties and is likely to do so too in the French elections too. This is positive for the Euro and leaves Eurozone shares and peripheral bonds looking attractive. (Adding in the West Australian election result, it wasn’t a good week for populists in Australia either!)

The US Federal Reserve

The Fed hikes, but continues to signal that future rate hikes remain conditional on improving growth and inflation and will likely remain gradual. It does not want to do anything to upset the recovery. The median dot plot of Fed officials’ interest rate expectations remained unchanged at three hikes for this year and another three hikes for next year, and the Fed continues to expect that future hikes will be “gradual”. This does not mean that the Fed poses no threat. Market expectations still look remarkably complacent and at some point in the next year, the focus will shift to the Fed allowing its balance sheet to start running down (by letting bonds roll off as they mature). This all points to a resumption of the bond bear market at some point.

 

Source: Bloomberg, Federal Reserve, AMP Capital

So far, share markets are following the pattern of the last twenty years where the initial Fed hike in a tightening cycle causes share market weakness (eg, June 2004, December 2015) but subsequent hikes have little impact as they are seen as consistent with stronger growth and profits, until monetary policy eventually becomes tight. With rates starting much lower and the process being far more gradual this time around, we still have a fair way to go before US monetary policy becomes tight enough to threaten the bull market in shares.

Of course, the US wasn’t the only country where interest rates were a focus in the last week. The People’s Bank of China increased key money market rates by 0.1% in a continuation of moves seen last month. However, the moves are very minor and look largely to be designed to stop growth from accelerating too far (given the commencement of a large number of infrastructure projects) rather than to slow the economy. The Fed’s move added to the case to move in order to minimise downwards pressure on the Renminbi.

By contrast, both the Bank of Japan and Bank of England left monetary policy on hold. In fact, the BoJ could be seen as being on autopilot, having committed to quantitative easing and keeping the 10-year bond yield at zero until inflation exceeds 2%. So the rest of the world still lags the US by a long way.

Finally, in Australia the National Australia Bank & Westpac raised rates for property investors and owner occupiers – the latter by 0.07% and 0.03% respectively. With global funding costs for banks having increased on the back of higher bond yields, out-of-cycle rate hikes for owner occupiers seemed likely at some point. Changes in investor rates have less impact on spending in the economy because they are tax deductible and investors are less sensitive to rate moves, but changes in owner occupier rates will cause more agitation. However, 3-7 basis point hikes are unlikely to have much economic impact and like the out-of-cycle rate hikes seen in November 2015 are likely to be ignored by the RBA. That said, if banks hike owner occupier rates by 25 basis points or more then the RBA may have to consider offsetting it with another cash rate cut. While the bank moves will lead to the usual waffle about whether the RBA still has much influence over lending rates it's noteworthy that out-of-cycle bank moves have been a regular occurrence since the GFC and yet this did not stop mortgage rates falling to record lows in response to RBA rate cuts. Changes in the cash rate remain the main driver of bank mortgage rates.

Source: RBA, AMP Capital

Major global economic events and implications

Most US data remains strong with small business confidence and regional business conditions indicators remaining robust, consumer sentiment up, manufacturing production up solidly, the NAHB’s home builders’ conditions index rising to its highest since 2005, housing starts up more than expected and labour market indicators remaining strong. Retail sales were softish though providing a brake on GDP growth (and the Fed). 

While President Trump’s budget proposals with massive spending cuts to pay for increased defence spending have caused much excitement, Congress drives the budget and will ultimately settle on a massively watered down compromise.

Chinese economic activity data for January/February indicated that solid growth momentum has continued into this year with industrial production and investment accelerating and real retail sales growth remaining strong. 

Australian economic events and implications

In Australia, two things happened over the last week. First, RBA Assistant Governor Bullock added to the message that more macro prudential measures could be on the way to cool down the Sydney and Melbourne property markets. This could include tougher interest rate tests and a reduction in the 10% growth cap for loans to property investors. Threats to the Sydney and Melbourne property markets are steadily building: state and Federal governments are shifting into gear to improve affordability; another round of macro-prudential measures looks on the way; the banks are starting to raise rates for owner occupiers out of cycle; all at a time when the supply of units is surging; and prices are ridiculous.

Second, economic data was mixed. Business conditions and confidence slipped but remain high according to the NAB survey. Consumer confidence edged up but remains around average. Jobs fell in February but full-time employment rose and leading jobs indicators point to solid jobs growth ahead. A rise in labour underutilisation to 14.6% is a concern though. 

Five reasons why the RBA won’t hike this year

Growth is still sub-par; labour underutilisation remains very high; underlying inflation is at risk of staying below target for longer; banks are raising lending rates out of cycle; and the $A has been going the wrong way. Another round of macro prudential controls to slow housing gives the RBA flexibility on this front. Our view remains no hike until the second half of 2018.

What to watch over the next week?

The G20 Finance ministers meeting will be watched for what it says on trade and currencies given the US focus on “fair trade” but is unlikely to have much market impact.

In the US, a speech by Fed Chair Yellen (Thursday) will be watched to see whether she seeks to temper the dovish market reaction to the Fed’s most recent meeting. On the data front, expect to see continued gains in home prices (Wednesday) but a fall back in home sales (also Wednesday and Thursday) after strong gains in January, February durable goods orders to show ongoing improvement and the March manufacturing conditions PMI (all Friday) to remain strong.

Eurozone business conditions PMIs for March (Friday) are also likely to remain at strong levels.

In Australia, the minutes from the last RBA Board meeting (Tuesday) are likely to confirm the RBA is comfortably on hold. But most interest will be around comments in relation to lending standards. Speeches by the RBA’s Ellis and Debelle will also be watched for any clues regarding rates and new macro prudential requirements. Expect ABS data to confirm a solid +2% gain in December quarter home prices (Tuesday).

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 – but there is a risk that any pullback may not come until seasonal weakness kicks in around May. However, we see share markets trending higher over the next 12 months helped by okay valuations, continuing easy global monetary conditions, fiscal stimulus in the US, some acceleration in global growth and rising profits.

Still low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds. They look to be starting their bear market again after a pause in the rise in yields since December. 

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 to around 3-4% this year, as the heat comes out of Sydney and Melbourne and rising apartment supply hits. 

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 $US0.72 and $US0.78 and this may continue for some time yet. 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 3 or 4 times and the RBA remains on hold). 

Eurozone shares rose 0.3% on Friday but the US S&P 500 slipped 0.1% despite solid economic data. The softish US lead saw ASX 200 futures fall 0.2% pointing to a 13 point decline at the open for the Australian share market on Monday morning.

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Fed on track for rate hike

Monday, March 13, 2017

By Shane Oliver

Investment markets and key developments over the past week

While US shares fell over the last week on nervousness ahead of a likely Fed rate hike, the loss was cut to 0.4% after the release of solid jobs data on Friday and most share markets rose with European shares up 0.3%, Japanese shares up 0.7%, Australian shares gaining 0.8% and Chinese shares flat. Bond yields pushed up in most regions – with yields in the US and Australia rising above their highs in December last year. Commodity prices were generally soft, with the oil price down 9% as US oil stockpiles rose with shale oil production looking like its offsetting OPEC production cuts. While the $US ended little changed, the $A fell to $US0.7544.

Solid US employment growth of 235,000 in February, a fall in unemployment and a slight rise in wages growth keep the Fed on track to raise interest rates again this coming Wednesday. By the same token, the pick-up in wages growth remains very gradual, and a likely rise in labour force participation will help keep it that way, which in turn, supports the view that future Fed rate hikes will be gradual too.

With short-term investor sentiment towards shares remaining very bullish, nervousness around a third Fed rate hike (along with worries around Trump, Eurozone elections or even North Korea) could help drive a correction in shares. However, with US monetary policy a long way from being tight, future rate hikes likely to be gradual and US economic data likely to be solid we don’t see it derailing the bull market in shares.

While I am not so worried about a Eurozone break up (support for the Dutch Freedom Party seems to be fading and Le Pen may have peaked in France at levels that won’t result in a victory in the second round), North Korea is worth watching. Tensions have clearly escalated, with North Korea’s latest missile test, South Korea employing the US THAAD missile defence system and China sanctioning both Koreas. This is likely to be just be another flare up in tensions to be followed by a cooling, but it’s a bit less certain than in the past, given North Korea’s nuclear capability and the US looking at “all options”. At least two things have been cleared up: despite pre-election rhetoric to the contrary, the US under President Trump is standing behind South Korea and Japan; and the upholding of President Park’s impeachment will see South Korea move forward on its political mess with new elections likely to see a new Democratic Party of Korea government take a less hard-line position towards North Korea.

The RBA stays put

RBA on hold at 1.5% for the seventh month in a row. As noted last week, we now expect the RBA to leave rates on hold for the rest of the year. Another rate cut is still possible, but it would require another leg down in underlying inflation. That said, talk of a rate hike this year is way too premature. Just because the US is hiking does not mean that the RBA will follow suit. The US is further into a growth recovery cycle than Australia, and since the Global Financial Crisis, RBA interest rate moves have diverged from those in the US - with the RBA hiking in 2009 and 2010 when the Fed was on hold and the RBA cutting rates last year when the Fed had increased rates.

More macro-prudential measures to slow housing may be on the way in Australia?

While I may be jumping at shadows, the latest post-meeting Statement from the RBA implied a bit of unease regarding lending to residential property investors and lending standards, probably on the back of the continuing surge in Sydney and Melbourne home prices. Most notably in the February Statement, it said that “supervisory measures have strengthened lending standards” whereas it's now saying that “supervisory measures have contributed to some strengthening of lending standards” which suggests the RBA thinks a further tightening in lending standards in relation to lending for housing may be required. More macro-prudential measures to slow property investment may be on the way, and this could take the form of lowering the threshold for growth in banks’ total lending to investors to say 7% year on year from 10% currently.

The past week saw the 100 year anniversary of the first Russian revolution (what a fizzer and waste of life the second one later the same year turned out to be!) and International Women’s Day. To help track the economic progress of Australian women, Financy (a women’s money website) and Data Digger (a data company) have produced an index that brings together six key indicators. What is interesting is that our biggest listed corporates are driving change at the very top with more women on boards and this is the main driver of the Financy Women’s Index since 2012. Hopefully, the realisation of the benefits of gender diversity on boards will trickle down through our workforce in the years ahead. 

Major global economic events and implications

US jobs data was strong, with payrolls up solidly, continuing very low jobless claims and a strong rise in imports driving a deterioration in the US trade deficit.

As expected, the ECB left monetary policy on hold, with President Draghi expressing a bit more confidence in the growth outlook but is yet to be convinced the rise in headline inflation is sustainable. He's still sounding dovish, albeit less so. We can't see the ECB announcing a tapering to its quantitative easing program for 2018 until after the French election is out of the way (and assuming Le Pen does not win).

Chinese macro-economic targets for 2017 from the People’s Congress contained few surprises – growth at 6.5%, inflation at 3% and the budget deficit as a percentage of GDP at 3% - and confirmed that the focus is on stability.

Chinese economic data was a bit mixed. While imports surged 38% year on year in February, pointing to strong domestic demand, exports surprisingly fell 1% year on year, which is contrary to evidence of stronger global growth. Both look a bit exaggerated and may reflect distortions due to the timing of the Chinese New Year holiday. Similarly, while producer price inflation accelerated further in February to 7.8% year on year, consumer price inflation fell, suggesting little pass through of the rise in producer prices. Again, holiday distortions may be playing a role. While it's clear that deflation has ended, producer price inflation is likely to slow going forward as the low base in commodity prices drops out of the annual calculation. Finally, credit growth slowed sharply in February. PBOC tightening may have played a role but the slowing largely reflects a reaction to the surge in January. Given the month to month volatility, it's best to take an average of the last two months, and it remains solid. Chinese data is consistent with further modest PBOC tightening, but it’s likely to remain gradual.

Australian economic events and implications

Australian retail sales bounced back in January after a couple of soft months, telling us that consumer spending has started 2017 on a solid note. While ANZ job ads fell in February, this followed a strong January and the trend points to solid jobs growth going forward. Finally, housing finance was stronger than expected in January due to another surge in lending to property investors – which is up nearly 28% from a year ago, highlighting that the dampening impact of APRA’s macro-prudential controls has worn off.

What to watch over the next week?

In the US, all eyes will be on the Fed, which on Wednesday is expected to announce its third rate hike for this cycle increasing the Fed Funds rate by 0.25% to a range of 0.75-1%. We have seen a run of solid economic data, the Fed is at or close to meeting its inflation and employment objectives, and such a move has been well flagged by Janet Yellen and others at the Fed.

As such, the money market is attaching a 100% probability to a hike on Wednesday. The main focus though will be the Fed’s commentary around the move which is likely to indicate that future moves will be conditional on continued economic improvement and that they will likely remain gradual. The so-called dot plot of Fed officials’ interest rate expectations could also shift up from showing three rate hikes this year to four. There may also be some discussion on when to start shrinking the Fed’s balance sheet, but the message is likely to remain that this will wait until the Fed Funds rate is closer to “normal” and that it will be achieved by letting maturing assets run off.

On the data front in the US, expect strength in small business optimism (Monday), a further rise in headline CPI inflation to 2.6% year on year, but a slight fall in core inflation to 2.2% year on year, a modest rise in retail sales and continued strength in the NAHB home builders’ index (all Tuesday), a rise in housing starts (Thursday) and a rise in industrial production (Friday). 

The main event in Europe will be the Dutch election on Wednesday. Recent polling points to a decline in support for the Geert Wilders' Eurosceptic Freedom Party from around 20% of the vote to less than 16%. It won't be able to form government which will ultimately come from a coalition of centrist parties. An outcome around these levels would be a positive sign for the Eurozone continuing to stay together and hence a positive for Eurozone shares.

The Bank of Japan (Thursday) is not expected to make any changes to monetary policy having committed in September to open ended quantitative easing until it exceeds its 2% inflation target, which at this stage, remains a long way away.

The BoE (Thursday) will probably make no changes to policy.

Chinese activity data for January/February (Tuesday) is expected to confirm that momentum in growth remained solid into 2017 with industrial production likely to pick up to 6.3% year on year (from 6% in December), retail sales likely to accelerate to 10.6% (from 10.4%) and fixed asset investment likely to accelerate to growth of 8.5% (from 8.1%).

In Australia, expect business conditions and confidence to remain at high levels according to the February NAB business survey (Tuesday), consumer confidence (Wednesday) to have risen slightly and February jobs data (Thursday) to show a 15,000 gain in employment and unemployment rising again to 5.8% on the back of higher participation.

Outlook for markets

Shares remain vulnerable to a short-term pull back as investor sentiment towards them is very bullish, the Fed is getting a bit more aggressive, Trump related uncertainty remains, various European elections could create some nervousness and North Korea is a potential risk factor as well. However, we see share markets trending higher over the next 12 months helped by okay valuations, continuing easy global monetary conditions, fiscal stimulus in the US, some acceleration in global growth and rising profits.

Still low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds. They look to be starting their bear market again after a pause in the rise in yields since December.

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 to around 3-4% this year, as the heat comes out of Sydney and Melbourne and rising apartment supply hits.

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 $US0.72 and $US0.78 and this may continue for some time yet. 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 three or four times and the RBA remains on hold).

Eurozone shares rose 0.2% on Friday, and the US S&P 500 rose 0.3% helped by a solid jobs report which points to the Fed hiking rates on Wednesday, but without having to get aggressive going forward. ASX 200 futures rose three points or 0.1%, pointing to a flat/mild positive start to trading for the Australian share market on Monday.

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