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

Keeping Brexit in perspective

Monday, June 27, 2016

The past week has been dominated by first the anticipation that Britain would vote to Remain within the EU that saw “risk on” in financial markets and shares rally followed by an abrupt move to “risk off” as the referendum saw the Leave vote win by 52% to 48%.

The vote to Leave poses risks: to the UK economy which will also face a period of political instability with PM Cameron to step down by October and pro-EU Scotland pushing for another independence referendum; to Eurozone stability over fears that some Eurozone countries may seek to follow the UK; and hence to global growth. It also threatens to add momentum to a move away from economic rationalist policies in favour of populism and a reversal of globalisation, which would be a negative for long term global growth.

Reflecting the worries about the impact on the UK and more significantly Europe financial markets reacted sharply in “risk off” fashion on Friday with the British pound (-8.1%), British shares (-3.1%), the Euro (-2.4%) and Eurozone shares (-8.6%) down sharply and this seeing global share markets down generally along with the Australian dollar. Safe haven assets such as bonds, the $US, Yen and gold have all benefitted. This could have further to go in the short term until some of the dust settles. A concern is that a rising $US in response to safe haven demand will weigh on the Renminbi (sparking new fears of capital outflows from China), commodity prices and emerging countries taking us back to the global growth fears we saw earlier this year.

However, it’s worth putting all of this in perspective. First the moves in some markets seen on Friday were exaggerated because the moves that occurred during the first four days of the last week when markets thought Remain would win had to be reversed. So, for example, while Eurozone shares fell 8.6% on Friday they only fell 2.6% over the last week. Over the week as a whole US shares lost 1.6%, Japanese shares lost 4.2%, Chinese shares fell 1.1% and Australian shares fell 1%. Bad but not monumental. Believe it or not the British share market actually rose 2% over the last week. While the British pound fell 8.1% on Friday it only fell 4.7% over the week as a whole and the $A actually rose 1% last week. It was similar with bonds and oil – big moves on Friday but only modest moves over the week

Second, Britain has only started down a process to exit and has a long way to go yet. It will first need a new PM then later this year formally notify its intent to exit which will then kick off a negotiation process that will then take up to two years to complete. This will determine the ultimate impact on the UK economy – either it will retain free trade access to the EU but have to continue to allow the free movement of people, agree to EU rules and regulations and contribute to its budget or forgo free trade altogether. At this stage its hard to see which way this will go. But the point is that for some time the UK will still be in the EU. 

Third, while the Brexit vote will likely trigger a guessing game as to which Eurozone country will try and follow its lead and ask for a similar referendum it’s doubtful that Eurozone countries will actually seek to leave because the hurdle to leave the Eurozone is higher than Britain leaving the EU as it will mean adopting a new currency, paying higher interest rates, etc. Just think of Greece despite its woes over the last few years consistently deciding to stay in the Eurozone. Countries to watch though are Italy following the recent success in municipal elections of the Eurosceptic Five Star Movement and maybe Spain given the success of Podemos.

Fourth, the Brexit vote is unlikely to be akin to a Lehman moment because conditions are radically different. Lehman came after a long period of global strength and a credit boom where liabilities and exposures were opaque. That is not the case now and Brexit has been talked about endlessly so is not the surprise Lehman was.

Finally, central banks have quickly adopted a “whatever is necessary” stance to provide liquidity to markets and support their economies, notably the Bank of England which is already providing £250bn. The ECB is monitoring the situation but its liquidity measures (eg. TLTRO) are probably more than enough at present. The more important point is that global monetary policy will remain easier for longer. The Fed certainly will be slowed further in raising rates because it won’t want to put more upwards pressure on the $US which is being boosted by safe haven demand. A G7 Statement decrying excessive currency volatility has arguably given Japan close to a green light to intervene to stop the Yen rising much further. Expect more BoJ easing soon which should help Japanese shares.

I am not so confident about British assets given the long period of uncertainty the UK will now face both economically and politically. However, the global bout of “risk off” underway is likely to provide a buying opportunity as Europe is likely to hang together, global monetary policy is likely to be even easier than previously thought and the global economy is likely to continue to see modest growth.

Given that only 2.7% of Australian exports go to the UK and that the Leave victory is unlikely to plunge Europe into an immediate recession the main impact on Australia will be on financial markets. This could affect short term confidence and may add to the case for the RBA to cut interest rates again particularly if banks increase their mortgage rates out of cycle due to higher funding costs flowing from an increase in lender caution. That said we expect the RBA to cut rates again anyway and a falling $A will continue to provide a shock absorber for the Australian economy. Overall, Brexit barely changes the risk of recession in Australia which remains low.

The key for investors is to either look through the short term noise caused by the Brexit decision or look for investment opportunities that it throws up as investment markets become oversold.

Just finally on Europe, the last week saw the German constitutional court approve the validity of the ECB's Outright Monetary Transaction (OMT) program, which partly underpins Draghi's 2012 commitment to do "whatever it takes" to preserve the Euro. This is a big relief because its rejection would have put a cloud over the ECB’s ability to respond to any turmoil in peripheral bond markets that may flow from the Brexit vote.

Now on to other things!

In Australia, the big event in the week ahead will be the Federal election (Saturday). Each side of politics is offering very different visions for the size of government:

Labor is focused on spending more on health and education and in the process allowing the size of the public sector to increase, funded by tax increases on higher income earners (retention of the budget deficit levy and cutbacks in access to negative gearing, the capital gains tax discount and superannuation). The ALP would also undertake a royal commission into banking and intervention in the economy is likely to be higher than under a Coalition government.

By contrast the Coalition is focused more on containing spending, and encouraging economic growth via company tax cuts and mild reforms. Despite the Coalition’s tilt to “fairness” with its super reforms it’s committed to keeping taxes down. It does plan to reinstate the Australian Building & Construction Commission but even with the double dissolution election it’s unclear whether it will get enough votes to do this.

At this stage the polls suggest the Australian election is too close to call. But it’s a big ask to see the ALP become the first opposition in 85 years to regain government after just one term as it will need to win 19 seats. As such betting agencies have the Coalition as favourite. However, the big issue may be what happens in the Senate with there being a good chance that the Greens and minority “parties” control the balance of power again acting as a huge constraint on the government, which would mean another de facto minority government, ie more of the same. Which in turn mean poor prospects for getting government spending under control over the next three years and for implementing serious productivity enhancing economic reforms.

Over the 7 weeks since the election was called the Australian share market has fallen 3.1%. The next table shows that 8 out of 12 elections since 1983 saw shares up 3 months later with an average gain of 4.8%. This may partly reflect relief at getting the election out of the way.

Australian shares before and after elections

Major global economic events and implications

Fed Chair Janet Yellen’s congressional testimony didn’t really add much. The key is that the Fed is “proceeding cautiously” to give it time to assess whether the US economy and inflation is on track with its expectations and given global uncertainties. Uncertainty and market turmoil flowing from the Brexit outcome is likely to further delay the Fed in terms of raising rates again.

US economic data was mostly good. While durable goods orders were weak, the June manufacturing PMI rose, home prices rose, home sales were strong, jobless claims fell sharply and home prices continue to rise. And the US’s top 33 banks passed a Fed stress test indicating that they have enough capital to withstand a severe economic shock (involving unemployment doubling to 10%.) In other words they are in good shape to withstand any shock flowing from Brexit.

The Eurozone composite business conditions PMI fell slightly in June with a decline in services (on Brexit fears?) offsetting a gain in manufacturing. It remains at a level consistent with moderate growth though.

Japan’s manufacturing conditions PMI rose just 0.1pt to a still weak 47.8 in June indicating that growth in June quarter is still struggling.

A couple of Chinese business conditions surveys moved in opposite directions for June with one up solidly and a small business PMI weakening. So bit of a wash there.

Australian economic events and implications

In Australia, the minutes from the last RBA Board meeting added little that was new with the RBA neutral and on the sidelines for now. However, our view remains that lower inflation and a too high $A on ongoing Fed delays will still see more easing ahead with the next cut likely in August.

Meanwhile Australian economic data over the last week was uneventful. March quarter house prices fell slightly according to the ABS but more timely private sector data suggests a renewed pick up since then particularly in Sydney. While population growth has slowed from its 2% peak late last decade to 1.4% last year it’s still contributing to solid underlying demand for housing.

NSW and Victoria are the top states for population growth, and flowing partly from this house price growth. Which in turn partly explains the good state of their budgets. Finally, skilled vacancies continue to see reasonable growth telling us that the labour market remains solid.

What to watch over the next week?

The focus in the week ahead will no doubt see continued reaction to the Brexit referendum, particularly given an EU leaders’ summit on Tuesday and Wednesday.

In the US, expect to see a further gain in home prices and a slight rise in consumer confidence (Tuesday), solid growth in personal spending and a slight rise in the core private consumption deflator to 1.7% for the year to May, but a slight fall in pending home sales (all Wednesday) and a slight rise in the ISM manufacturing conditions index (Friday) to around 51.5 (Friday).

In the Eurozone expect bank lending (Monday) and economic confidence readings for June (Wednesday) to remain around levels consistent with continued moderate economic growth. Core inflation data for June (Thursday and unemployment data (both Friday) will also be released. The outcome of the Spanish election on Sunday may also add to short term uncertainties regarding the Eurozone.

In Japan, expect a slight fall in industrial production (Thursday), a deterioration in the June quarter Tankan survey reflecting the recent earthquake and continued softness in household spending but the jobs market (all Friday) is likely to remain solid helped by the falling workforce. Core inflation (also Friday) is expected to fall to 0.6% yoy in May.

In Australia, apart from Saturday’s election, expect the trend in new home sales (Wednesday) to remain modestly down, ABS job vacancies for the 3 months to May to rise consistent with monthly vacancy data and continued moderate credit growth (Thursday) and a slight softening in home price momentum in June (Friday) according to CoreLogic. The AIG’s manufacturing conditions PMI (Friday) will also be released.

Outlook for markets

The aftermath of the Brexit vote could see more volatility in shares in the short term. However, beyond near term uncertainties, we still see shares trending higher this year helped by relatively attractive valuations, ultra easy global monetary conditions and continuing moderate global economic growth.

Lower and lower bond yields point to a soft medium term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity, low inflation and ongoing shocks like Brexit. That said, the recent bond rally has taken bond yields to ridiculously low levels leaving them at risk of a sharp snapback at some point.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors.

Capital city dwelling price gains are expected to slow to around 3% over the year ahead, as the heat comes out of Sydney and Melbourne thanks to toughening lending standards and pockets of oversupply. Prices are likely to continue to fall in Perth and Darwin, but price growth may be picking up in Brisbane.

Cash and bank deposits offer poor returns.

While the Brexit outcome knocked the $A lower, it’s still higher than it should be and the longer term downtrend looks likely to continue as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed eventually resumes hiking, commodity prices remain in a secular downswing and the $A sees its usual undershoot of fair value. The $A is still likely to fall to around $US0.60 in the years ahead.

Eurozone shares lost 8.6% on Friday night and the US S&P 500 lost 3.6% in response to the Brexit vote. However, since the Australian share market largely responded to the Brexit outcome on Friday, ASX 200 futures actually rose 3 points or 0.1% indicating a basically flat start to trade for the Australian share market on Monday.

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Is the Brexit frenzy justified?

Monday, June 20, 2016

By Shane Oliver

The past week has been dominated by Brexit worries which pushed down most share markets and combined with a very dovish US Federal Reserve, pushed bond yields down as well. US shares fell 1.2%, Eurozone shares lost 2.4%, Japanese shares were also hit by the absence of further Bank of Japan monetary easing and fell 6%, Chinese shares lost 1.7% and Australian shares fell 3.7%. The fall in bond yields saw German 10-year yields fall briefly below zero for the first time and Australian 10-year bond yields fall briefly below 2% to a new record low. Commodity prices were mixed with oil down but metals up a bit. The Australian dollar was little changed.  

Source: Global Financial Data, AMP Capital

Why the Brexit frenzy and is it justified? The Brexit vote (Thursday) is fast approaching and nervousness in financial markets has been building over the last few weeks, particularly as the Leave campaign – focussing on the more emotive topic of immigration - has been showing a lead over Remain. The agitation in financial markets reflects two things. First, concern about the impact of Brexit on the UK economy via reduced trade access to the EU, its financial sector and labour mobility (which has been estimated at somewhere around -2% of UK GDP) and this has been weighing on UK assets, notably the British pound. But Britain ain’t what it used to be (eg it only takes 2.7% of Australia’s exports). The real concern globally is that a Brexit could lead to renewed worries about the durability of the Euro to the extent that it may encourage moves by Eurozone countries to exit the EU and Eurozone which in turn, could reignite concerns about the credit worthiness of debt issued by peripheral countries and lead to a flight to safety out of the Euro into the $US which could put renewed pressure on emerging market currencies, the Renminbi and commodity prices. And then we are back in the turmoil we saw earlier this year! 

However, with Eurozone shares falling 8% in the last few weeks, it could be getting overdone. If Remain wins then recent market moves should reverse with the British pound and Eurozone shares likely to bounce particularly sharply. If Brexit wins there could be more to go in the short term (ie shares down, bond yields down, British pound and Euro down and $US, Yen and gold up) but this will likely prove to be a buying opportunity in relation to European and global shares as Europe is likely to hang together as it did through its sovereign debt crisis. The hurdle for a Spain, an Italy or a France to leave the Eurozone is much higher than for the UK to leave the EU as they would end up with a depreciated currency and higher debt costs. Just think of Greece which despite all its woes consistently wants to stay in the Eurozone. In fact, support generally remains high for the Euro. It would probably also be the case that Europe would ultimately be better off without Britain as it would remove a brake on greater integration.

Will Brexit happen? While the polls have been moving in favour of the Leave campaign, I still lean to a Remain outcome: undecided voters are likely to favour the status quo, telephone polls which were more accurate in last year’s UK election still favour Remain and the murder of a pro Remain British politician by a mad Brexiteer may swing support back to Remain. 

Meanwhile, the Fed remains on hold and very dovish. It revised growth forecasts down fractionally to 2% for this year and next and slightly upgraded its inflation forecasts but it was a bit less positive on the US jobs market. More significantly the so-called "dot plot" showing expectations of the 17 Fed meeting participants for the Fed Funds rate still sees two hikes this year but six members now see only one hike this year (up from just one in March). The "dot plot" also lowered the profile for interest rates in the years ahead once again in the direction of already lower market expectations. See the next chart. Short of a big rebound in June payroll employment I can't see the Fed moving before September at the earliest. The key is that the Fed remains cautious and is allowing for global risks. Market expectations for a Fed rate hike this year now look too dovish (just 38% chance of a hike by December), but the key is that the Fed is not going to knowingly do anything that threatens the US or global growth outlook. 

Source: US Federal Reserve, AMP Capital

As if there isn’t enough to worry about, the terror threat loomed its head again with a horrible attack in Orlando. This appears to have more in common with the Sydney Lindt Café attack with another nutcase, but it doesn’t annul the horrible loss of life. Investment markets appear to be getting desensitised to terror attacks because if they don’t damage economic infrastructure, they are unlikely to have much financial impact. The Orlando attack has played into the hands of Donald Trump though.

Major global economic events and implications

US data remains consistent with a modest rebound in June quarter GDP growth. Industrial production was soft in May but manufacturing conditions in the New York and Philadelphia regions bounced back, the NAHB home builders’ conditions index rose and housing starts were stronger than expected, US retail sales rose strongly in May for the second month in a row and jobless claims remain low. The Atlanta Fed's GDPNow growth tracker is pointing to GDP growth of 2.8% annualised this quarter. Meanwhile, core CPI inflation was 2.2% year-on-year in May which is consistent with the Fed’s preferred measure of inflation slowly heading back to its 2% target.

The Bank of Japan disappointed yet again, but with inflation well below target, shaky growth and the Yen now rising to a 12-month high, pressure remains for additional quantitative easing which we still see being delivered, perhaps in July.

Chinese data for May was mixed with slowing growth in investment but stable growth in retail sales and industrialist production. Combined with stronger exports and stable business conditions PMIs growth looks to be tracking sideways at 6.5-7% but policy looks like it will have to remain stimulatory.

Australian economic events and implications

Australian data remains consistent with okay economic growth with business conditions remaining solid in May, consumer sentiment holding onto most of the rate cut related bounce in May and employment up solidly in May, with unemployment remaining unchanged at 5.7%. However, there are some concerns with business confidence down in May, full time employment growth remaining weak and labour market underutilisation as measured by unemployment and underemployment rising to a high 14.2% which will maintain downwards pressure on wages growth. So while growth looks okay, there is nothing here to prevent further monetary easing.

What to watch over the next week?

The focus in the week ahead will no doubt be on the Brexit vote (Thursday). Since polling stations won’t close until 10pm UK time on Thursday night, we may not get a clear indication as to the outcome until 7am the next day (around 4pm Friday in Sydney). If it’s a very close vote, it could take longer.  

The latest Spanish election (June 26) will also be watched closely. While opinion polls point to a stronger performance from left wing Podemos, following its alliance with a far left party, they also indicate neither a centre-left or centre-right coalition are likely to achieve a majority. The outcome may continue to be a minority centre-right government which won’t reverse the economic reforms of recent years, but will be constrained in what it can do. Fortunately most of the heavy lifting on Spanish economic reforms has already been done.

The German constitutional court will deliver its final ruling on the validity of the ECB's Outright Monetary Transaction program (Tuesday) which partly underpins Draghi's 2012 commitment to do "whatever it takes" to preserve the Euro.

In the US, the highlight will likely be Fed Chair Yellen’s Congressional Testimony (Wednesday) which is likely to repeat that the Fed remains dovish and cautious in raising rates. On the data front, expect a further gain in home prices and a rise in existing home sales (both Wednesday), but a fall back in new home sales and the June manufacturing conditions PMI to be around 50.5 (both Thursday) and underlying durable goods orders to show modest growth (Friday).

In the Eurozone, consumer confidence and business conditions PMIs (Thursday) will be released.

In Australia, the minutes from the RBA’s last meeting (Tuesday) will be watched for any guidance around the outlook for interest rates. On the data front expect ABS data to show a 1% gain in March quarter home prices (also Tuesday).

Outlook for markets

Short term event risk – the Brexit vote, Spanish election, Australian election, US Republican and Democrat party conventions - could drive continued short-term share market volatility. However, beyond near-term uncertainties, we still see shares trending higher this year, helped by relatively attractive valuations, ultra easy global monetary conditions and continuing moderate global economic growth. 

Lower and lower bond yields point to a soft to medium term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity and low inflation. That said, the recent bond rally has taken bond yields to ridiculously low levels, leaving them at risk of a sharp snapback.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors. 

Capital city dwelling price gains are expected to slow to around 3% over the year ahead, as the heat comes out of Sydney and Melbourne thanks to toughening lending standards and pockets of oversupply. Prices are likely to continue to fall in Perth and Darwin, but price growth may be picking up in Brisbane. 

Cash and bank deposits offer poor returns. 

A bounce from oversold levels and Fed rate hike delays are clearly supporting the Aussie dollar in the short term. But the longer term downtrend looks likely to continue, as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed eventually resumes hiking, commodity prices remain in a secular downswing and the dollar sees its usual undershoot of fair value. The dollar is still likely to fall to around $US0.60 in the years ahead.

Eurozone shares rose 1.2% on Friday as Brexit fears receded a bit, but the US S&P 500 fell 0.3% led down by technology and health care shares. ASX 200 futures were unchanged, pointing to a flat start to trade for Australian shares on Monday.

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Brexit blues

Wednesday, June 15, 2016

By Shane Oliver 

Despite a positive start initially with US shares making it within 1% of an all-time high, share markets fell over the last week with increasing nervousness ahead of the June 23 Brexit vote particularly weighing on Eurozone shares. For the week Eurozone shares fell 2.7%, Chinese shares lost 0.8%, Japanese shares fell 0.3%, US shares fell 0.2% and Australian shares lost 0.1%. Expectations of an ongoing delay in Fed tightening and a flight to safety around Brexit fears pushed bond yields down and the US dollar up. Metal prices fell and while the oil price rose it gave up most of its gains later in the week. Although the Aussie dollar spiked higher after the RBA left rates unchanged it ended the week little changed.

Event risk is now looming large with notably the Fed meeting in the week ahead and more importantly, the Brexit vote on June 23rd. With Brexit polls now showing a swing in favour of a Leave vote, investment markets are starting to focus more on the risks around Brexit and the threat this poses to the British economy (with the British pound falling 1.4% on Friday) and to renewed worries about the stability of the Eurozone. All of which is seeing a flight to safety pushing bond yields down and the $US up. My view remains that undecided voters will stick with the status quo in the Brexit vote much as we saw in the Scottish referendum, but it’s a very close call.   

Will the decision by benchmark provider MSCI on June 14 on whether to include Chinese mainland (or A) shares in its emerging market and world equity benchmarks really have much impact on Chinese shares? Yes it could cause a near-term flurry of interest, but given that any inclusion will be phased in over time, the short-term impact may prove to be brief and marginal. Just like the Shanghai-HK share connect that generated much enthusiasm initially. Including Chinese A shares in global equity benchmarks over the very long term will boost foreign interest in Chinese shares which is good, but other drivers are far more significant in the short term.

The Fed is delaying again, and for good reason. After a brief flurry of heightened expectations for another rate hike soon, the Fed Chair Janet Yellen while upbeat and cautious at the same time, described low payroll growth in May as “disappointing” and “concerning” and dropped any reference to raising interest rates "in the coming months". So the prospect of a Fed rate hike in the week ahead looks very low (although maybe not quite the market's assigned probability of zero), the late July meeting looks too soon as there will only be one more monthly payroll report by then, so September looks more likely for the next move, but as we have seen for a long time now, the Fed has been consistently too hawkish on rates relative to market expectations.

In Australia, the RBA left interest rates on hold at 1.75% as expected. But its failure to reintroduce a comment something like "the low inflation outlook provides scope to ease rates further if necessary" into its post-meeting statement coming on the back of diminishing expectations for any imminent Fed rate, hike saw the Aussie dollar briefly push back to $0.75. This undid nearly half of its recent plunge from $US0.78 to a post rate cut low of $US0.7145. Talk of an easing bias is cheap and yet the RBA has made this mistake repeatedly over the last four years, which has only served to delay the adjustment in the Aussie dollar. Is the RBA done? Maybe, but I doubt it given the ongoing downside risks to inflation.

Along with the RBA, the Reserve Banks of New Zealand and India also left interest rates on hold in the past week, but the Korean central bank surprised with a rate cut to 1.25% and maintained an easing bias and the Russian central bank cut its cash rate by 0.5% taking it to 10.25%, indicating that global monetary conditions are still easing.

Which brings me to bond yields. How low can they go? Australian 10-year bond yields this week have hit a new record low of 2.09%. There are two key influences. First, the fall to record-low bond yields globally is seeing flows into bond markets still offering relatively high yields like Australian bonds, which in turn, drives their yields lower.

Australian bond yields at record lows

Source: Global Financial Data, Bloomberg, AMP Capital 

Locally the plunge in the cash rate is also impacting. Since the ten year bond yield reflects investor expectations of the average cash rate over the next ten years (along with compensation for locking your money away over time) and since such expectations tend to extrapolate current conditions off into the future the longer the cash rate stays low or falls further the greater the risk the bond yield will push into new record low territory catching down to bond yields in the US and much lower yields in Germany and Japan. The chart below shows the Australian 10 year bond yield against a 24 month trailing moving average of the cash rate which assumes that the cash rate remains at 1.75% for the next year. This would imply a sub 2% yield for Australian ten year bonds soon. In fact, if global bond yields continue to plunge the Australian bond yield could be below 2% in the next week or so. By year end we see bond yields being a bit higher, but the risks are on the downside.

Record low cash rates driving record low bond yields

Source: Bloomberg, AMP Capital

Major global economic events and implications

  • May US payrolls were disappointing but a new high in job vacancies and very low jobless claims tell us that labour demand remains strong and layoffs remain low.
  • Eurozone March quarter GDP growth was revised up to 0.6% quarter-on-quarter, telling us growth is continuing at a reasonable pace.
  • Japanese March quarter GDP growth was also revised up slightly to 0.5% quarter-on-quarter from 0.4%, which is good, but growth in Japan has been bouncing between negative and positive quarters suggesting it may not be sustained.
  • April machinery orders and May economic sentiment were both weak.
  • Chinese exports fell 4% year-on-year in May, which was in line with expectations, but the fall in imports moderated to just -0.4% year-on-year, which is indicative of higher commodity prices and possibly improved domestic demand. Meanwhile, consumer price inflation fell to 2% year-on-year but producer price deflation continued to abate which is a good sign.

Australian economic events and implications

  • Australian housing finance commitments fell in April led by a fall in investor finance, suggesting APRA measures continue to bite. Of course, this was before the May rate cut. Meanwhile, the MI Inflation Gauge fell in May, indicating disinflationary pressures may be intensifying in the June quarter.

What to watch over the next week?

In the US, the focus will be on the Fed (Wednesday) which is expected to leave interest rates on hold. A June hike was always unlikely, given the potentially disruptive Brexit vote taking place a week later, but disappointingly weak May employment data and a lack of urgency in comments from Fed Chair Yellen indicate a June move is very unlikely. Rather, the focus will be on the post meeting statement, Janet Yellen’s press conference, Fed economic forecasts and the so-called “dot plot” of Fed officials interest rate expectations, and while we expect the Fed to signal that it still sees two rate hikes this year, the overall message is likely to remain that it will be cautious in raising rates given low inflation and the uncertainties around growth. Given a likely desire to see clear evidence that US activity indicators and jobs have picked up, the Fed is more likely to wait till September before moving again.

  • Meanwhile on the data front in the US, expect to see solid growth in May retail sales (Tuesday), a fall in industrial production (Wednesday), core CPI inflation (Thursday) edge up to 2.2% year-on-year, the NAHB home builders’ survey (also Thursday) rise slightly but housing starts (Friday) fall slightly.
  • The Bank of Japan (Thursday) will be watched closely. After the disappointing lack of action at its last meeting the BoJ may now surprise the market, with additional easing particularly given that the G7 meeting in late May is now out of the way.
  • Chinese May data for industrial production, retail sales and fixed asset investment (Monday) is likely to show stable growth.
  • In Australia, expect the NAB business conditions index (Tuesday) to fall a bit, but the Westpac/MI consumer sentiment index (Wednesday) to hold recent gains. May jobs data (Thursday) is likely to show a decent gain, but watch the full time versus part-time mix which has been soft lately and higher participation may drive a slight rise in unemployment to 5.8%.

Outlook for markets

With US shares a bit short-term overbought from a technical perspective, significant event risk in the next month or so (Fed meeting, Brexit vote, Spanish election, Australian election, US Republican and Democrat party conventions) could drive a further increase in short-term share market volatility. However, beyond the risk of near-term volatility, we still see shares trending higher this year, helped by a combination of relatively attractive valuations, ultra easy global monetary conditions and continuing moderate global economic growth. 

Very low bond yields point to a soft medium-term return potential from them, but it’s hard to get bearish in a world of fragile growth, spare capacity and low inflation. This has been the story for most of this decade now!

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors. 

Capital city dwelling price gains are expected to slow to around 3% over the year ahead, as the heat comes out of Sydney and Melbourne thanks to toughening lending standards and pockets of oversupply. Prices are likely to continue to fall in Perth and Darwin, but price growth may be picking up in Brisbane. 

Cash and bank deposits offer poor returns. 

After its fall from $US0.78 the Aussie dollar became oversold and due for a bounce, which we have started to see. However, the bounce is likely to be limited, and the longer term downtrend looks likely to continue as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed eventually resumes hiking, commodity prices remain in a secular downswing and the Aussie dollar sees its usual undershoot of fair value. The dollar is still likely to fall to around $US0.60 in the years ahead.

Eurozone shares lost 2.5% on Friday and the US S&P 500 fell 0.9% as Brexit fears increased. The poor global lead saw ASX 200 futures lose 61 points or 1.1% pointing to a weak start to trade for the Australian share market next week.

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Has Janet Yellen lost her nerve?

Monday, June 06, 2016

By Shane Oliver

Shares were mostly soft over the last week. Chinese shares had a decent 4.1% gain, but US shares were flat thanks to a soft jobs report on Friday, Eurozone shares fell 2%, not helped by renewed Brexit concerns, Japanese shares lost 1.1% on disappointment about the lack of more fiscal easing and Australian shares fell 1.6% - weighed down by a fall in the iron ore price and worries that stronger than expected GDP growth means reduced prospects for RBA rate cuts.

Bond yields and the $US fell as weak US jobs growth in May is likely to further delay the next Fed rate hike, but commodity prices were mixed, with oil down but metals up. The Aussie dollar rose 2.5% mostly in response to the soft US jobs report. 

Weak US employment in May adds to the case for the Fed to further delay rate hikes. The May labour market report was much weaker than expected with payrolls up just 38,000 and wages growth stuck at 2.5% year-on-year. While unemployment fell to 4.7%, this was only because participation fell. This will unnerve the Fed and means that a June hike is likely now off the table with the US money market’s probability of June hike now back at just 4%. July remains our base case for the next hike but it would require a decent rebound in June payrolls, so the risk is now that the Fed will be delayed to September. However, while the May jobs report was a shocker and will impact the Fed, there is a danger in reading too much into it. As we regularly see in Australia, monthly jobs reports can be highly unreliable with occasional rogue results. Very low jobless claims tell us that the US labour market is still reasonably solid, so there is no reason to wheel out the recession fears again.  

Looks like I was too soon to speak of diminishing Brexit risks a week ago, with the latest round of polls seeing support for the “Remain” and “Leave” options converging again. Here are some key points on the June 23 Brexit vote: 

  • First, even if there is majority support to Leave it could be two years or so before the terms of the exit are agreed. 
  • Second, a victory for Leave would be seen as a negative for the UK given the threat it would pose to its access to EU markets, its financial sector and labour mobility. The size of this impact would depend on what sort of exit is negotiated with the EU but has been estimated at somewhere around -2% of UK GDP. This would adversely affect UK assets including the pound. Britain could in time agree on a trade deal with the EU (like Norway has) but this would involve a loss of sovereignty as Britain would have to agree to EU rules with no say in setting them. 
  • Third, the real issue (given the diminishing significance of the UK economy) would be perceptions of the impact on the Eurozone. A Brexit would not be of the same order as a Grexit because Britain is not in the Eurozone. But it could lead to renewed concerns about the durability of the Euro to the extent that it may be seen as encouraging moves within Eurozone countries to exit the EU and Eurozone (eg, a Frexit) which in turn could reignite concerns about the credit worthiness of debt issued by peripheral countries, lead to a flight to safety out of the Euro into the $US, which could in turn put renewed pressure on emerging market currencies, the Renminbi and commodity prices. All of which could trigger a bout of nervousness in global financial markets. Ultimately, the latter seems unlikely though, as it would more likely trigger increased pressure for integration in the Eurozone. Markets won’t know that initially though. 
  • Fourth, a Leave victory may be seen as reinforcing the anti-globalisation forces already evident globally. 
  • Fifth, while this sounds negative, a Brexit has been subject to constant debate lately and is seen as the biggest “tail risk” by fund managers according to a recent survey, so it should be at least partly allowed for. 
  • Finally, while the polls show the vote is close, it is notable that the Remain vote has had the edge over time and my assessment is that a majority of British voters will chose to stick with the status quo, much like the Scots did last year. So I attach a 70% probability in favour of Remain.

Has China really overinvested?

This seems to be taken as a given and then used to justify a bearish-forever view on commodity demand, comparisons to Japan, etc. But I am still a bit sceptical. Two things have particularly added to my scepticism lately. First, if the Chinese housing market really saw a massive over supply of housing with ghost cities etc, then why do Chinese property prices take off every time the regulators take the brakes off? Soufun's 100 city property price index rose 1.7% in May and is now up 10.3% year-on-year. Second, the following stats on the number of airports in each country caught my eye: the US 13,513; Canada 1,467; Russia 1,218; Germany 539; Australia 480 (must include little ones); China 507. Not much sign of an overinvestment in China here! And I suspect the same applies in relation to much of China's infrastructure. 

Australia's minimum wage is to rise 2.4% to $17.70/hour, but it's unlikely to have much macro impact as it only affects 15% or less of the workforce, so won't affect overall wages growth much. While Australia's minimum wage in US dollar terms was way above OECD country norms when the Aussie dollar was above parity, the 30% plus plunge in the $A means it's not as much of an issue now from a global competitiveness point of view. 

Major global economic events and implications

US data was mixed with strong April consumer spending, continued gains in home prices, a surprise rise in the May manufacturing conditions ISM index, low unemployment claims, a smaller than expected trade deficit and stronger than expected auto sales but soft payroll employment, a fall in services sector conditions and softer than expected construction spending and consumer confidence. Meanwhile, the core private final consumption deflator was unchanged at 1.6% year-on-year in April compared to the Fed’s 2% target and the Fed’s Beige Book observed “modest” economic and wages growth and “slight” price rises.

As expected the ECB remained in implementation and assessment mode at its June meeting, but the ECB’s continuing sub target inflation forecasts (1.6% for 2018) and President Draghi’s dovish comments indicate it retains an easing bias. Eurozone economic confidence improved for the second month in a row remains at levels consistent with continued okay economic growth, unemployment remained high at 10.2% and bank lending continued to increase modestly. Meanwhile, inflation ticked up slightly but core inflation at 0.8% year-on-year remains well below target.

As widely expected, Japanese PM Abe has delayed the scheduled second increase in its GST rate to October 2019, with “bold” fiscal stimulus likely to be announced in the months ahead. Meanwhile, labour market data for April was solid and industrial production rose, but it’s still trending down on a year ago and household spending remains weak.

Chinese May business conditions PMIs were flat or down slightly and remain up on recent lows, telling us that GDP growth is continuing to run along between 6.5-7%.

India remains a star performer globally with GDP up 7.9% over the year to the March quarter.

Australian economic events and implications

Australian data released over the last week was mostly strong with GDP much stronger than expected and up 3.1% year-on-year, building approvals rebounding back towards record levels, house price momentum picking up again led by Sydney, okay retail sales growth and the trade deficit continuing to contract. However, there were some soft numbers though with a fall in new home sales and mixed PMIs for May.

The bottom line is that thanks to a combination of booming resource exports as various projects complete (the third phase of the mining boom) along with a rebalancing of the economy towards consumer spending, housing and services, the economy is a long way from the much feared recession and there is no sign of one on the horizon.

However, there are some dampeners. Demand growth in the economy remains very weak with private final demand virtually flat; surging resource export volumes won’t create many jobs; nominal growth in the economy (at 2.1% year-on-year) is very weak, reflecting the commodity price slump and very low inflation; this in turn is weighing on profits; and meanwhile, the seeming return to boom conditions in the Sydney and Melbourne property market and another spike in apartment approvals poses an increasing risk of a property bust down the track.

Overall, our conclusion is that given the various cross currents, the RBA won’t be rushing into another rate cut in the months ahead but will cut again later this year. Meanwhile, if the renewed strength in home prices isn’t temporary expect a renewed round of APRA measures to slow mortgage lending.

What to watch over the next week?

In the US, a speech by Fed Chair Janet Yellen on Monday is likely to confirm that the chance of a June rate hike has been substantially reduced by the soft May payroll report in the US.

US data on job openings (Wednesday) and consumer sentiment (Friday) will also be released.

China's data for May will be released with exports and imports (Wednesday) likely to show a slight improvement and inflation data (Thursday) likely to show a further abatement of producer price deflation but CPI inflation remaining around 2.3% year-on-year. Growth in industrial production, retail sales and investment (June 12) is likely to be little changed from April. Credit data is expected to show a pick up from the softness seen in April.

Interest rates will again be the focus in Australia, with the RBA meeting Tuesday and likely to leave them on hold. While lower than expected wages growth for the March quarter and a still too high Australian dollar support the case for another rate cut to combat downside risks to inflation, solid real economic growth and the RBA's desire for "further information" after cutting last month is likely to see the RBA wait until August before cutting rates again. Meanwhile, expect ANZ job ads (Monday) to point to a softening trend for jobs growth, but housing finance for April (Wednesday) to show a 3% rise.

Outlook for markets

Significant event risk in the next month or so (Fed meeting, Brexit vote, Spanish election, Australian election) and the fear of “sell in May and go away, come back on St Leger’s Day” could drive an increase in short-term share market volatility. However, beyond near-term volatility, we still see shares trending higher this year helped by a combination of relatively attractive valuations, ultra easy global monetary conditions and continuing moderate global economic growth. 

Very low bond yields point to a soft medium-term return potential from them, but it’s hard to get bearish in a world of fragile growth, spare capacity and low inflation. 

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors. 

Capital city residential property price gains are expected to slow to around 3% this year, as the heat comes out of Sydney and Melbourne. Prices are likely to continue to fall in Perth and Darwin, but price growth is likely to pick up in Brisbane. 

Cash and bank deposits offer poor returns. 

After its fall from $US0.78 the Australian dollar is oversold and due for a bounce, which we may be starting to see. However, the bounce is likely to be limited and the longer term downtrend looks to be resuming as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed eventually resumes hiking, commodity prices remain in a secular downswing and the Australian dollar sees its usual undershoot of fair value. 

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Why a Brexit is a bad idea

Monday, May 30, 2016

By Shane Oliver

Share markets had a good week helped by a combination of improved confidence regarding US growth, increasing signs that the global oil market is rebalancing (helping the oil price and energy shares) and Greece and its creditors agreeing on a new debt deal. Combined, this saw most share markets rally for the week and gains in oil and metal prices. However, bond yields fell and the Aussie dollar was little changed as was the $US generally.

The message from the US Fed remains that a rate hike is getting closer, but July still looks more likely than June. Fed regional presidents continue to wax lyrical on rate hikes (which makes me wonder whether Fed transparency is really a cacophony) but it’s worth reiterating that many of them don’t vote and they tend to be more hawkish that key Fed decision makers. In terms of the latter comments by Fed Governor Jerome Powell (who always gets to vote) - they suggest a lack of urgency given the Brexit vote and the low risk of waiting, suggesting that July is more likely for a hike than June.

Why are markets so far more relaxed about a Fed rate hike? Several reasons;

  1. More confidence in US/Chinese and global growth;
  2. Fed caution and delays have provided confidence it is not going to be reckless;
  3. The global oil market is rebalancing, helping stabilise the oil price and reducing the risks for oil producers, and;
  4. Less concern about a collapse in the Renminbi. Of course, this could all change if the $US takes off big time again, but so far so good.

While the oil market may be rebalancing (with supply cutbacks in the US and outages in Canada, Nigeria and Libya) this is not the case for iron ore, where the price is on its way back down as the global steel glut remains. After spiking to $US70/tonne early this year, it’s now back below $US50.  

Is the Brexit risk receding?

Polls appear to be edging in favour of a Remain outcome from the June 23 referendum as opposed to Leave.

In my view, the case to Leave is dubious because it would be a big negative for the UK financial sector and would either harm UK free trade with the EU (if no trade deal is agreed after a Leave vote) or lead to reduced national sovereignty if a trade deal is cut (because the UK would have to agree to EU rules, but have no say in setting them).

Perhaps this logic is starting to set in.

The end of the migration crisis in Europe (sea arrivals have collapsed to 12,000 in April from 220,000 last October) may also help the Remain case.

No Grexit scare this summer. I know it didn't get much coverage (why bother to report good news, it doesn't sell), but Greece, the EU and the IMF agreed a new debt which will see €10bn disbursed. This is good news because it means there won't be another Grexit scare this summer. Bond yields in Spain and Italy also fell in response.

Major global economic events and implications

US data again provided mixed messages over the last week. On the one hand, business conditions PMIs slipped in May and core durable goods orders were weak in April. But against this home prices continue to rise, new and pending home sales surged, the advance goods trade balance for April was better than expected and jobless claims fell again. The overall impression remains that US growth has bounced back in the current quarter with the Atlanta Fed’s GDPNow GDP tracker now running at 2.9%, but growth is averaging out around 2% or slightly less so the trend is still not overly strong. But a long way from the recession obsession of earlier this year.

The news out of Europe was okay. Sure manufacturing and services PMIs fell in May but only fractionally and they continue to point to moderate economic growth. Meanwhile, consumer confidence and the German IFO index picked up.

Japanese data was soft with a further fall in the May manufacturing conditions PMI to a weak 47.6 and a higher trade surplus due to weaker imports. GDP may be falling again. Meanwhile, national core inflation remained low at just 0.7% year-on-year in April, with Tokyo data pointing to a further fall in May. Expect more fiscal and monetary stimulus in the next month or so.

Australian economic events and implications

In Australia, the business investment slump continues with March quarter construction and capital expenditure data (or capex) falling more than expected. Mining investment remains the main driver. What's more business plans point to ongoing mainly mining driven weakness over the year ahead. The ABS' capex intentions surveys are continuing to fall compared to estimates made a year ago (see the next chart) and point to a roughly 20% decline in capex in the next financial year driven by a further 35% slump in mining investment. So capex remains an ongoing detractor from growth. 

Source: ABS, AMP Capital

However, there are some positives: dwelling construction rose again in the March quarter; the slump in mining investment over the year ahead will take it back to around its long-term norm as a share of GDP so it's growth detraction will fade (see the next chart); and the outlook for non-mining investment is starting to look a bit less bleak with non-mining capex plans edging up from year ago levels. That said the economy will still need help from lower interest rates and a lower Aussie dollar to help offset the growth gap over the year ahead from falling mining investment.

Source: ABS, AMP Capital

RBA Governor Stevens didn't really add anything new on the interest rate outlook but provided a solid defence of its inflation targeting approach describing it as "easily the best monetary policy framework we have ever had", and indicating he "does not agree" with proposals to adjust the target. I agree.

What to watch over the next week?

In the US, the May manufacturing conditions ISM (Wednesday) and jobs data (Friday) will be watched as a guide as to how the US economy performed in May, and both will take on greater than normal significance ahead of the Fed’s June 14-15 meeting. The manufacturing ISM index is expected to fall slightly to around 50.5, payroll employment is expected to rise by an okay 170,000, unemployment is expected to fall back to around 4.9% and average wage earnings growth may edge up slightly from 2.5% year-on-year. Meanwhile, expect stronger personal spending for April but core private consumption inflation remaining around 1.6% year-on-year, continued gains in home prices and an improvement in consumer confidence (all due Tuesday) and a solid reading for the non-manufacturing ISM (Friday).

In the Eurozone, the ECB (Thursday) is unlikely to announce any changes to its monetary stimulus program given the big extra stimulus it provided earlier this year. Expect confidence readings for May (Monday) to hold around levels consistent with moderate growth, core inflation for May to have remained low at around 0.7% year-on-year and unemployment (both Tuesday) to have edged down to 10.1%.

In Japan, expect jobs data to remain solid but household spending and industrial production to remain soft (Tuesday). 

Chinese manufacturing conditions PMIs for May (Wednesday) are expected to slip slightly from April levels. So the message out of China is likely to remain one of continued growth around the 6.5 to 7% level. No bust, but not growth acceleration either.  

In Australia, the key focus will be on March quarter GDP (Wednesday) which is expected to show growth of 0.7% quarter-on-quarter and annual growth slowing back to around trend of 2.7% year-on-year helped along by consumer spending, housing investment and net exports but constrained by falling capex. Meanwhile, expect falls in April data for new home sales (Monday) and building approvals (Tuesday) after solid gains in March, continued moderate credit growth (also Tuesday) and a 0.2% gain in April retail sales (Thursday). Data for home prices, the trade deficit and PMIs will also be released.

Outlook for markets

Expect short term share market volatility to remain high, with significant event risk in the next month or so (Fed meeting, Brexit vote, Spanish election, Australian election) and the fear of “sell in May and go away, come back on St Leger’s Day”. However, beyond near term volatility, we still see shares trending higher this year helped by a combination of relatively attractive valuations, ultra easy global monetary conditions and continuing moderate global economic growth. 

Very low bond yields point to a soft medium-term return potential from them, but it’s hard to get bearish in a world of fragile growth, spare capacity and low inflation. 

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors. 

Capital city residential property price gains are expected to slow to around 3% this year, as the heat comes out of Sydney and Melbourne. Prices are likely to continue to fall in Perth and Darwin, but price growth is likely to pick up in Brisbane. 

Cash and bank deposits offer poor returns. 

After its recent fall from $US0.78 the Aussie dollar is technically oversold and due for a bounce. However, any bounce is likely to be limited and the longer term downtrend looks to be resuming as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed resumes hiking, commodity prices remain in a secular downswing and the Aussie dollar sees its usual undershoot of fair value.

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Will Janet Yellen pull the trigger on interest rates?

Monday, May 23, 2016

By Shane Oliver

Financial markets saw a bout of renewed worries about Fed rate hikes in the past week but shares managed to shrug it off and end higher. Over the week, US and European shares rose 0.3%, Japanese shares rose 2% helped by a fall in the Yen, Chinese shares inched up 0.1% and Australian shares rose 0.4% led by health and energy shares. In fact, for the year to date the Australian share market at +1% is outperforming US, European, Japanese and Chinese shares. Bond yields generally rose as investors moved to factor in a higher probability of a Fed hike next month and this also saw the $US push higher again. While the stronger $US weighed on the $A and metal prices, the oil price managed to gain 3%.

After five months of a lot of noise but inaction, the Fed is clearly edging towards another rate hike, with the June meeting “live” for a hike and a move in the summer looking likely. The minutes from the Fed’s last meeting were far more hawkish than the statement released immediately after the meeting, the key comment being that most Fed meeting participants felt that a hike at the Fed’s June 14-15 meeting would likely be appropriate if incoming data was supportive. In recent weeks, it’s arguable that data has been supportive of a hike, with signs that June quarter GDP growth is picking up and continued labour market strength and inflation edging towards the 2% target. So quite clearly, the June meeting will see serious consideration given to a hike and this has seen the US money market’s probability of a June hike move up to 28% from close to zero only a week or so ago.

My view is that while a June Fed hike is now a close call, a July or September move is more likely because: the Brexit vote will take place just one week after the June meeting and several Fed officials have indicated that the Fed will consider that; Fed voting members appear to be more cautious than the full range of Fed meeting participants who include non-voting regional presidents who tend to be more hawkish; and the Fed will likely need more time to assess recent data releases which have only just started to improve again. So at this stage, our base case is for a July move.

More broadly we remain of the view that Fed hikes will be very gradual with constrained global growth and the risk that the $US will start to surge higher again creating renewed weakness in commodity prices, Renminbi deprecation, pressure on emerging countries and a brake on US growth all acting to constrain by how much and how quickly the Fed can hike.

Ho hum PEFO. The Australian Pre-election Economic and Fiscal Outlook was a bit boring in that it was based on the same underlying assumptions that were in the Budget because the economic and fiscal outlook “has not materially changed” since the Budget on May 3. So as a result the budget deficit projections are identical as those in the Budget. Fair enough, but a couple of risks seem to have heightened since the Budget. First, wages growth has slowed to a new record low of 2.1% and is now running well below the assumed 2.5% wages growth for the year ahead. Related to this the Budget/PEFO inflation assumptions are now above those of the RBA. Second, the iron ore price has fallen 13% since the Budget making the Budget/PEFO iron ore price assumption of $US55/tonne look a little less secure. So the risk with the PEFO projections as with the Budget is that the assumed 6% pa plus revenue growth will not be achieved and so the return of the Budget to surplus will be pushed out even further. Unfortunately, the whole PEFO process lost significant credibility around the 2013 Federal election with the new Coalition Government revising up the budget deficit projections over the four year forward estimates compared to the 2013 PEFO by a total of $68bn just four months after PEFO was released.

What’s happened to autumn? In Sydney its been more like summer lately which reminds me we are still in the grip of a serious El Nino weather phenomenon. An El Nino sees trade winds that normally blow across the Pacific to the west (La Nina) weaken or reverse causing more rain in the east Pacific and less rain/drought in the west Pacific. The Southern Oscillation Index, which measures sea surface pressures across the Pacific and is one indicator of it, remains deep in El Nino territory, pointing to lower farm production and higher food prices, but so far there hasn’t been much sign of this. As we have seen in the past the link between El Nino and farm production varies, but it’s still worth keeping an eye on.

Source: ABS, AMP Capital

Major global economic events and implications

US data was a bit messy with softer readings for regional manufacturing conditions surveys, a bounce in industrial production in April but after two months of falls, home builder conditions and housing starts basically trending sideways, but a fall back in jobless claims and stronger leading economic indicators and existing home sales. The overall impression is that GDP growth is bouncing back, albeit modestly, after the March quarter’s slow down to 0.5% annualised growth. The Atlanta Fed’s GDPNow growth tracker is currently estimating 2.5% annualised growth for this quarter. CPI inflation bounced in April due to higher oil prices, but core inflation dipped slightly to 2.1% yoy.

Japanese GDP rose more than expected in the March quarter as did machine orders but growth has been bouncing between positive and negative quarters against a zero growth trend for the last year now and the Kumamoto earthquake may be a bit of a dampener in the current quarter.

China saw the housing market continue to hot up in April, particularly in Tier 1 cities. Meanwhile, the People’s Bank of China moved to try and damp down concern about the sharp slowing in credit seen in April indicating that the drop was temporary and that it will continue to support growth. Clearly it doesn’t want sentiment to swing back to the negative on China again. Our base case remains that Chinese growth will come in around or a bit above 6.5% this year. No boom but no bust either.

Australian economic events and implications

In Australia, while the minutes from the RBA’s last Board meeting were interpreted as suggesting that the RBA would not be rushing to cut rates again as it awaits “further information”, March data showing a new record low in wages growth suggests that another rate cut as early as June or July is possible. While labour market data for April was pretty much as expected, increasing signs of softness after last year’s strength – declining hours worked, falling full time jobs and mixed indicators from forward looking labour market indicators - also support the case for further monetary easing. So we remain of the view that the RBA will cut rates two more times this year taking the cash rate down to 1.25%. Our base case for the next move is August but it could come earlier. 

What to watch over the next week?

In the US, the focus will be a speech by Fed Chair Janet Yellen (Friday) for any guidance regarding the prospects for a rate hike at the Fed’s June 14-15 meeting. While the latest Fed minutes indicated that the June meeting is “live” for a possible hike, Yellen is likely to be a bit more cautious. On the data front expect: the manufacturing conditions PMI (Monday) to remain around an index reading of 51; a bounce in new home sales (Tuesday); continuing gains in home prices (Wednesday); modest growth in durable goods orders and a slight rise in pending home sales (both Thursday); and an upwards revision to March quarter GDP growth to 0.8% annualised from the initially reported 0.5%.

In the Eurozone, May business conditions PMIs (Monday) are likely to remain around levels associated with continued moderate economic growth.

In Japan an improvement in the manufacturing conditions PMI (Tuesday) will be looked for and CPI data (Friday) is likely to show deepening deflation at a headline level and very low inflation on a core basis.

In Australia, March quarter construction data (Wednesday) and capex data (Thursday) are likely to show continued softness in business investment led by mining. Capex intentions for 2016-17 will hopefully show signs of improvement in non-mining investment though, consistent with reasonable business conditions of late. A speech by RBA Governor Steven’s (Tuesday) will also be watched for any clues regarding the interest rate outlook.

Outlook for markets

Expect short term share market volatility to remain high. Fed worries are coming back into focus and this could mean more uncertainty around the $US, Renminbi and commodity prices and the old saying “sell in May and go away, come back on St Leger’s Day” always adds to nervousness around this time of year. However, beyond near term volatility, we still see shares trending higher this year helped by a combination of relatively attractive valuations, further global monetary easing and continuing moderate global economic growth.

Very low bond yields point to a soft medium term return potential from them, but it’s hard to get bearish in a world of fragile growth, spare capacity and low inflation.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors.

Capital city residential property price gains are expected to slow to around 3% this year, as the heat comes out of Sydney and Melbourne. Prices are likely to continue to fall in Perth and Darwin, but price growth is likely to pick up in Brisbane.

Cash and bank deposits are likely to provide poor returns – and are getting even poorer!

After its recent fall from $US0.78 the $A is technically oversold and due for a bounce. However, any bounce is likely to be limited and the longer term downtrend looks to be resuming as the interest rate differential in favour of Australia narrows as the RBA continues cutting the cash rate and the Fed eventually resumes hiking, commodity prices remain in a secular downswing and the $A undertakes its usual undershoot of fair value. 

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Two more rate cuts on the cards

Monday, May 16, 2016

By Shane Oliver

Share markets had a mixed ride over the last week with ongoing global growth fears and messy US earnings news. US shares lost 0.5% and Chinese shares remained under pressure falling another 3%. However, Eurozone shares gained 0.5%, Japanese shares rose 1.9% helped by a lower Yen and Australian shares gained 0.7% with the recent RBA rate cut continuing to help. Bond yields generally fell, commodity prices were mixed with oil up but metals down and the $A fell below $US0.73 as the $US edged up slightly.

Another Greek blow up looks unlikely for this summer. Renewed Grexit fears helped set off share market turbulence around mid-last year (and mid-2010, mid-2011 and mid-2012) but the same looks unlikely this time around. With Greece agreeing various reforms on pensions, taxes and contingent spending cuts it looks likely to pass the first review of its latest aid program. European creditors are now starting to discuss debt relief based around longer maturities and lower interest rates. There is a way to go, but at this stage it looks like another Grexit scare won't be back in the headlines this year. 

Impeachment trial of Brazilian President Rousseff is only the beginning. While Brazil’s Senate vote to commence an impeachment trial of Dilma Rousseff was initially greeted positively by the Brazilian share market, Brazil has a long way to go to get back on track. Vice-president Michel Temer who is now acting president looks to be making market friendly appointments to his cabinet and looks likely to try to rein in Brazil’s 5% of GDP budget deficit with spending cuts and tax hikes. However, the huge 20% plus rally in Brazilian shares that has already occurred this year in anticipation of Rousseff’s impeachment is likely to be tested as the trial will take many months, then the outcome can be challenged, and even if Rousseff is ultimately impeached, President Temer would then remain in office until 2018 (and he is unlikely to undertake the sort of reforms Brazil needs and in the meantime, fiscal cutbacks are likely to worsen Brazil’s already deep recession and in turn heighten political tensions which could see them reversed). A new election would help but that could be some time away and it's not clear that it will result in a government focussed on undertaking the necessary economic and political reforms to get Brazil's economy back in shape. In other words, Brazil’s problems are much bigger than Rousseff - they have just been exposed by the commodity slump.

Lowering Australia's inflation target would be madness. Back around 2007-08 when inflation had pushed above 4% (both headline and underlying) some commentators were seriously arguing that the RBA cannot fight rising global commodity prices and so should just raise its inflation target. Now we're hearing that with inflation below target, the RBA should just lower its target with some using the same argument about falling global commodity prices. This is nonsense. The whole point of having an inflation target is to anchor inflation expectation around the target. If it is just raised or lowered each time it looks like being seriously breached due to commodity price movements or whatever - then those expectations - which workers use to demand wage gains, companies use in setting wage increases and prices and which help drive future inflation - will simply move up or down depending on which way the target is changed. This is why it took so long to get inflation back under control in the 1970s and 1980s and why Japan has struggled to end deflation over the last two decades. The RBA should simply ignore calls to lower the target.

Major global economic events and implications

US data was stronger with a big gain in April retail sales, improved consumer sentiment, a rise in small business optimism and strong readings for job openings and hiring suggesting that the labour market is strong and the slowing in payrolls seen in March may be an aberration. That said, unemployment claims have edged up over the last couple of weeks, although the rise over the last week may be due to special factors as it was driven by just New York. Meanwhile, a rise in producer prices suggest an edging up in underlying price pressures. A June or July Fed rate hike still looks unlikely but there is a reasonable chance of a September hike.

Eurozone industrial production fell but German factory orders rose.

Japan's leading economic indicator rose in March, but various economic confidence indicators fell, not helped by the Kumamoto earthquake and underlying wages growth remained soft.

Following the lead from business conditions PMIs, Chinese industrial production, retail sales, fixed asset investment, exports, imports, lending and money supply growth all slowed to varying degrees in April, leaving them in the growth ranges they have been in over the last year or so. Cutting through the volatility, it’s clear that there is no sustained acceleration in Chinese growth, but then again there is no collapse either. More likely it’s just stabilising somewhere around the 6.5-7% GDP growth range. Chinese CPI inflation was unchanged at 2.3% year-on-year in April, with non-food inflation remaining low at just 1.1% year-on-year. There was good news though with producer price deflation continuing to recede from -4.3% year-on-year to -3.4% year-on-year. This is a good sign. Meanwhile, the decline in underlying foreign exchange reserves continued to slow suggesting that capital outflows are continuing to slow as a degree of stability has returned to the Renminbi (albeit this is partly dependent on what the $US does).

Indian economic data disappointed with weaker than expected industrial production and higher inflation.

Australian economic events and implications

Australian data was a bit light on, but the highlight was a bounce in consumer confidence that took it above average and to its highest since January 2014 – rate cuts work at least in the short term! This doesn’t appear to have been driven by reaction to the Budget (which looks neutral relative to last year), but rather appears to reflect reaction to the RBA’s latest rate cut which is a positive sign. That said, consumer sentiment is volatile month-to-month and remains below levels associated with strong growth.  

Source: NAB, Westpac/MI, AMP Capital

Meanwhile Australian housing finance was a bit stronger than expected in March driven by loans going to investors to buy new properties. The broad trend is still down but there has been a bit of a bounce in investor loans. Strength here is likely to be limited though given ongoing APRA vigilance. Finally, ANZ job ads slowed a bit again in April, consistent with some moderation in employment growth after last year’s surge.

Reflecting the downside risks to inflation, we are now allowing for two more rate cuts from the RBA this year taking the cash rate down to 1.25%.

What to watch over the next week?

In the US, expect to see gains in the NAHB home builders’ conditions index (Monday), housing starts and industrial production (both Tuesday) and existing home sales (Friday). Manufacturing conditions surveys for the New York and Philadelphia regions will give an early guide as to how conditions are tracking in May. While CPI inflation (Tuesday) is likely to show a solid rise reflecting the recent bounce in oil prices core CPI inflation is expected to fall back slightly from 2.2% year-on-year to 2.1%. The minutes from the Fed’s last meeting (Wednesday) are likely to confirm that the majority view at the Fed is cautious and dovish.

In Australia, the minutes from the RBA’s last meeting (Tuesday) will be a bit dated given the recent Statement on Monetary Policy but no doubt they will be watched for any further clues regarding the interest rate outlook. On the data front expect to see March quarter wages growth (Wednesday) remain low around 2.2% year on year and April labour market data (Thursday) to show weak jobs growth after the solid gain seen in March and a slight bounce in unemployment back to 5.8%. 

Outlook for markets

Expect short term share market volatility to remain high. May always seems to be a nervous time as now everyone knows about “sell in May and go away, come back on St Leger’s Day”, global growth remains fragile and uncertainty lingers around the Fed and China. However, beyond near term volatility, we still see shares trending higher this year helped by a combination of relatively attractive valuations, further global monetary easing and continuing moderate global economic growth. 

Very low bond yields point to a soft medium term return potential from them, but it’s hard to get bearish in a world of fragile growth, spare capacity and low inflation. 

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors. 

Capital city residential property price gains are expected to slow to around 3% this year, as the heat comes out of Sydney and Melbourne. Prices are likely to continue to fall in Perth and Darwin, but price growth is likely to pick up in Brisbane. 

Cash and bank deposits are likely to provide poor returns – getting even poorer! 

The ongoing delay in Fed tightening still poses short term upside risks for the $A. However, any short term rebound is likely to be limited and the longer term downtrend looks to be resuming as the interest rate differential in favour of Australia narrows as the RBA continues cutting the cash rate and the Fed eventually resumes hiking, commodity prices remain in a secular downswing and the $A undertakes its usual undershoot of fair value. 

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Global growth worries return

Monday, May 09, 2016

By Shane Oliver

Share markets had a messy week as the return of growth worries weighed with Japanese shares down 3.4%, Eurozone shares down 2.6%, Chinese shares down 0.9% and US shares losing 0.4%. Despite falls in commodity prices and some earnings downgrades from the banks including one cutting its dividend, Australian shares rose 0.8% helped by the RBA’s rate cut and an implicit easing bias in its Statement on Monetary Policy (SOMP). Global growth concerns also pushed bond yields down, weighed on commodity prices and were helped along with the RBA’s rate cut pushing the $A down by 3%. While the $US rebounded, its rise just looks like normal volatility in a downtrend.   

Donald Trump wins the Republican primaries. So much for my view that Donald Trump won't get a majority of delegates leading to a contested GOP convention. Cruz and Kasich have now dropped out. So it seems hurling around divisive abuse and advancing play school solutions to complex problems is the way to secure the Republican nomination (Mexicans and Chinese are rapists, implicating Cruz's father in the assassination of JFK, etc). This must be hard for decent Republicans. Fortunately polls - particularly of independents who will decide the outcome at the presidential election - show Hillary Clinton (who only needs 15% of remaining delegates from Democrat primaries to secure a majority) well ahead of Trump. Trouble is that Trump will now try and swing back to the centre (ie, tone down his rhetoric - if that is possible!) and an upset (eg, a terrorist attack on US soil leading to support for a "strong man", a US recession or criminal charges against Hillary Clinton in relation to her use of emails as Secretary of State) means that a common sense victory in the US presidential election six months away is not assured.

Apart from big changes to superannuation, the Australian 2016-17 Federal Budget was rather uninspiring, with trivial income tax cuts and nothing really new in terms of contributions to long term economic growth. Sure there's $50bn in infrastructure spend over six years, but only just over $1bn of that is new. The plan to reduce corporate tax rates for small business is welcome, but for large business, it will be a long time coming. The real focus of the Budget seemed to be on presenting the Government as "fair" (hence the super hit to higher income earners) ahead of the July 2 election.

The changes to superannuation are consistent with the move to set its objective as providing income in retirement and they still leave superannuation as highly tax preferred compared to alternatives. The concern though is that yet another big change to super and the retrospective nature of some of those changes will further affect confidence in it - likely pushing the perception of super as the “wisest place for saving” in the Westpac/MI consumer survey to another new low, that it will adversely affect the supply of patient long term saving available to help grow the Australian economy and that it will further dampen incentive in the economy because it’s a defacto tax hike for high income earners at a time when the Australian tax system is already highly progressive (the top 5% already contribute 33% of tax revenue). The moves may also push funds into other strategies such as negative gearing.

 

Source:Westpac/Melb Institute Consumer Survey, AMP Capital

RBA cuts the cash rate to a record low of 1.75%, more to come. In cutting for the twelfth time in this rate cutting cycle - which started in November 2011 - the RBA cited a lower outlook for inflation after the much lower than expected March quarter inflation outcome and backed this up in its quarterly Statement on Monetary Policy (SOMP) by lowering its inflation forecasts for this year to just 1 to 2%, and to 1.5-2.5% for 2017 and into 2018. A desire to see a lower Australian dollar was arguably another consideration. While the RBA’s SOMP made no substantive changes to its growth forecasts which see growth running around 3%, it is rightly concerned about preventing sub-target inflation from becoming entrenched in expectations and the associated risk that this could drift into sustained deflation, a la Japan. And it would prefer to manage any risk of reinvigorating home price strength in Sydney and Melbourne via macro prudential regulation rather than run the risk of leaving interest rates too high. With the RBA’s ultra-low inflation forecasts being based on market expectations for one more rate cut at the time the SOMP was prepared the implication is that the cash rate may have to fall even further (to maybe 1%) to be confident that inflation will return to within the target range. So by implication, the RBA has signalled a strong easing bias. Given the downside risks around inflation, the upside risks for the $A if the Fed continues to delay, and continued weak demand growth, we'll see another rate cut around August, with the high risk of another move in November. 

The announcement that RBA Deputy Governor Philip Lowe will replace Glenn Stevens as Governor in September is no surprise and welcome. Dr Lowe’s expertise and experience at the RBA leaves him well placed for the role. He has a similar approach to Glenn Steven’s so it’s hard to see significant changes to the operation of monetary policy. Meanwhile, Glenn Stevens' huge contribution to macro-economic stability in Australia should be acknowledged. While the RBA has made some mistakes on rates, these are minor, and it has quickly changed tack once it has worked out its mistake – eg, through the GFC and the recent easing cycle. More broadly, Glenn Stevens’ quick rate cuts in 2008-09 played a huge role in Australia avoiding the recession that hit all other OECD countries. At the same time, RBA monetary policy has helped anchor inflation around the target zone of 2-3%. While some may criticise Governor Stevens for overseeing housing bubbles and poor affordability, these problems owe to the poor housing supply response, rather than monetary policy settings. 

Major global economic events and implications

US data was mixed, with weaker manufacturing conditions in April and soft payroll employment but stronger services sector conditions, stronger construction activity and a smaller trade deficit. The April jobs report showing a weaker than expected gain in payrolls of 160,000 will no doubt add to fears about a US slowdown and so a June Fed rate hike is now even less likely and the chance of a July move is low as well. However, monthly payrolls can be volatile, the soft April gain may be payback for mild weather in the March quarter, jobless claims are around their lowest since 1973 and wages and hours worked were stronger. So it would be wrong to read too much into the soft headline April payroll increase. Meanwhile, the US March quarter profit reporting season is now 87% done. Results generally have been better *than expected – with 76% beating on earnings and 54% beating on revenue – but not by much, as earnings growth for the quarter has only improved to -7.4% year-on-year from around -9.5%.

Chinese business conditions PMIs fell back slightly in April. Fortunately, they remain above recent lows and the moves were too minor to read much into. The overall impression remains that China is not going to have a bust but it won't be rebounding either. Meanwhile home prices rose again in April as inventory levels continue to fall. Quite clearly the "ghost city" bust of a few years ago came to nothing and the property market is getting hot again.

Australian economic events and implications

Australia saw mainly solid data over the last week with another bounce in building approvals (albeit the trend remains down), solid home price gains in April, a rebound in new home sales, modest growth in retail sales and a sharp improvement in the trade deficit for March. In fact, net exports look like contributing around 0.75% or so to March quarter GDP growth as resource export volumes along with services exports surge. So the recession some still look for is likely to remain elusive. But there was a slight slippage in business conditions in April.

What to watch over the next week?

In the US, expect to see a rebound in April retail sales after weakness in March with reasonably solid core retail sales growth, a slight improvement in consumer sentiment and continued low producer price inflation (all due Friday). Data on small business optimism and job openings will also be released.

Chinese economic activity indicators due May 14th will be watched closely to see if the improvement in momentum seen in March has continued into April. Slight setbacks in business conditions PMIs suggest that they are likely to be mixed though, with a slight slowing in industrial production (to 6.5% yoy from 6.8%), little change in retail sales growth (at around 10.5%) and a continued pick up in investment growth. Credit and money supply growth is likely to have remained strong. While CPI inflation is likely to remain around 2.3% year-on-year, producer price deflation is likely to continue to abate.

In Australia, expect the latest RBA rate cut and the modest tax cuts in the Budget to have driven a rebound in consumer confidence (Wednesday) after April’s fall and March housing finance to reverse the gain seen in February. A speech by the RBA’s Malcolm Edey (Thursday) will be watched for clues on interest rates.

Outlook for markets

Expect short term share market volatility to remain high. May always seems to be a nervous time, as now everyone knows about “sell in May and go away, come back on St Leger’s Day”, global growth remains fragile and uncertainty lingers around the Fed. However, beyond near term volatility, we still see shares trending higher this year helped by a combination of relatively attractive valuations, further global monetary easing and continuing moderate global economic growth. 

Very low bond yields point to a soft medium-term return potential from them, but it’s hard to get bearish in a world of fragile growth, spare capacity and low inflation. 

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors. 

Capital city residential property price gains are expected to slow to around 3% this year, as the heat comes out of Sydney and Melbourne. Prices are likely to continue to fall in Perth and Darwin, but price growth is likely to pick up in Brisbane. 

Cash and bank deposits are likely to provide poor returns – getting even poorer! 

The ongoing delay in Fed tightening still poses short term upside risks for the $A. However, any short term rebound is likely to be limited and the longer term downtrend looks to be resuming as the interest rate differential in favour of Australia narrows as the RBA is cutting the cash rate and the Fed eventually resumes hiking, commodity prices remain in a secular downswing and the $A undertakes its usual undershoot of fair value. 

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RBA expected to cut and budget preview

Monday, May 02, 2016

By Shane Oliver

Investment markets and key developments over the past week

Australian inflation (or deflation) has set the RBA up for a rate cut on Tuesday, or at least it should have. While it would be wrong to conclude that Australia is on the brink of sustained deflation – as falls in petrol and fruit prices won’t be repeated – the big surprise in the March quarter inflation data was that price weakness was broad based with underlying inflation running at its lowest annual rate on record. Both headline and underlying inflation are now running well below the RBA’s 2-3% inflation target. The risk is that thanks to a combination of deflationary pressures globally, soft demand domestically and very weak wages growth, inflation could remain well below target for an extended period. This is a risk the RBA cannot ignore and is best to address early before inflation expectations fall too far and under target inflation becomes entrenched. As a result, we think that the RBA should, and most likely will, cut the official cash rate by 0.25% taking it to 1.75% when it meets on Tuesday.  But it’s not just low inflation that justifies a rate cut. Other reasons include the risk of a soft spot in growth later in the year as housing slows, the still too strong $A and to offset upwards pressure on bank mortgage rates from higher bank funding costs. Will the banks pass a cut on in full? Probably not – “funding cost” arguments may see only 0.15% or so of a 0.25% cut passed on.

Most share markets pulled back a bit over the last week not helped by some disappointing earnings results from US tech stocks and surprise inaction by the Bank of Japan. Shares had become overbought so were due a bit of a pause or pull back. US shares fell 1.3%, Eurozone shares lost 2.5%, Japanese shares fell 5.2% and Chinese shares fell 0.7% but Australian shares gained 0.3%. This wrapped up a mostly positive month for shares with Australian shares up 3.3% and modest gains in US and Eurozone shares but falls in Japanese and Chinese shares. Bond yields were mixed over the last week: up in the Eurozone, but down in the US and Australia. Commodity prices rose as the $US fell, but the $A got hit by heightened RBA rate cut expectations.

The big surprise over the last week was the decision by the Bank of Japan to not undertake more monetary easing despite soft economic data, inflation well below target, strength in the Yen and the earthquakes. Maybe the BoJ is waiting to assess a fiscal response from the Japanese Government and get the May 26-27 G7 summit to be held in Japan out of the way. Our assessment is that more BoJ easing is just a matter of time. Failure to do more soon though risks unwinding all the progress on inflation expectations seen under Abenomics, particularly with the Yen breaking to ever higher levels.

By contrast the Fed’s April meeting delivered no surprises, with the Fed remaining gradual. A June rate hike is unlikely as US data probably won’t have improved enough by then and markets may be nervous given the Brexit vote on June 23. The US money market’s assessment of just a 26% probability of a July hike appears a bit low though – I would think it’s around 50%. The key message from the Fed is that it will not do anything that upsets the outlook for global and US growth.

Major global economic events and implications

Here we go again - another weak start to the year for the US economy with March quarter GDP up just 0.5% annualised. This was as expected and needs to be seen in perspective given that weak March quarter growth has been the norm over the last 20 or so years with average growth of 1% annualised ahead of a rebound to average 3% growth in the June quarter. So far the evidence is mixed though as to whether growth in the current quarter is rebounding. In the past week we have seen weak readings for new home sales, durable goods orders, personal spending and consumer confidence but solid readings for the services conditions PMI, pending home sales and the goods trade deficit and continued very low readings for jobless claims. Combined with ongoing low growth in wages, it’s all consistent with the Fed remaining very gradual. 

US Q1 earnings have seen some mixed results for high profile tech stocks but have generally been better than expected. 62% of S&P 500 stocks have now reported with 77% beating on earnings and 57% beating on sales. 

Eurozone data was good with an acceleration in March quarter GDP growth, another fall in unemployment and a tick up in bank lending and economic sentiment both of which are consistent with ongoing growth. A fall in core inflation to just 0.8%yoy will keep the ECB ultra easy though.

Japanese data was messy with strong labour market readings (although this may be due partly to a declining labour force) and a rebound in industrial production but a dip in inflation back into negative territory, a fall in core inflation to just 0.7% year on year, poor household spending and a fall in small business confidence. The impact from the Kumamoto earthquakes won’t be helping and so further monetary easing is still needed.

What to watch over the next week?

In the US, the big focus will be on the ISM manufacturing conditions index Monday and labour market data Friday. Regional surveys point to a fall back in the April ISM manufacturing index to around 51, leaving it still well above the low of 48 seen in December but April jobs growth is likely to remain solid with a 200,000 gain in payrolls, unemployment remaining at 5% and wages growth edging up slightly.

In China, a further slight increase is expected in the official manufacturing conditions PMI (Sunday) for April and the Caixin manufacturing PMI (Tuesday).

In Australia, after the RBA Board meeting (see above), the focus will shift to the 2016-17 Federal Budget on Tuesday night. This budget is more significant than usual for two reasons. First, it will likely be the Government's main economic statement ahead of a likely July 2 election and as such the Government will want to include some sweeteners. Second, because it comes after several years that have seen the return to surplus pushed out further and further, the ratings agencies are losing patience with the threat of a downgrade to our sovereign AAA rating if they are not happy. And the ratings agencies have a point. We are now looking at a 12-13 year run of budget deficits which swamps the 7 years seen in the 1990s and the 5 years in the 1980s. And this despite not even having had a recession. Rather we have done this thanks largely to a “dumb country” combination of politicians ramping up spending commitments on a whole range of things without facing up to how they will be paid for.

These two considerations point in opposite directions. And so it will be a difficult balancing act for the Government.

Fortunately some improvement in the jobs outlook and the iron ore price should offset lower wages growth to allow this Budget to be the first in several years to more or less hold the line on the last set of budget projections, which in this case are the MYEFO projections from late last year. As such, we expect the 2016-17 deficit projection to come in around $34bn (2% of GDP) and that for 2017-18 to be around $23bn. The return to surplus could be pushed out to 2021-22 though. The Government is likely to forecast 2016-17 GFP growth of 2.75%.

Key measures are likely to include: raising the $80,000 income tax threshold slightly; removal of the deficit levy on schedule next year; a crackdown on tax avoidance by multinationals to fund cutting the corporate tax rate; reduced superannuation concessions for high income earners; a hike in tobacco excise; and more funding/inducements for infrastructure spending likely involving some form of partnership with private sector partners that want to take advantage of the Governments low borrowing costs. Overall, the Government is expected to aim for a cap on revenue as a share of GDP and to limit spending growth in contrast to the Labor opposition which is more likely to focus on growing tax revenue (via reduced access to negative gearing, the capital gains tax discount and superannuation) to fund increased spending.

Should the Government worry about maintaining its AAA rating? Yes. Its loss may not ultimately have much impact on government borrowing rates. And if a downgrade knocks the $A down that would be good. So no worries here. Rather the real concern would be that the loss of the rating would signal an undoing of all the work in the 1980s and 1990s by political leaders on both sides of politics to set public finances onto a sustainable path. 

On the data front in Australia, expect the CoreLogic RP data home price index to show continued modest growth in home prices in April and the AIG manufacturing conditions PMI and NAB business conditions index to fall back slightly from the high levels seen in March (all Monday), building approvals (Tuesday) too fall slightly, a 0.3% gain in March retail sales and a fall in the March trade deficit to a still big $2.9bn (both Thursday). The RBA will release is quarterly Statement on Friday which will be watched for downwards revisions to inflation forecasts.

Australian economic events and implications

Apart from the much lower than expected March quarter inflation data, export and import prices both fell more than expected pushing the terms of trade down yet again, producer price inflation remained low and credit growth remained moderate. In fact annual growth in credit to property investors is now less than that to owner occupiers.

Outlook for markets

Expect short term share market volatility to remain high as we head into May (“sell in May and go away, come back on St Leger’s Day”), global growth remains fragile and the Fed eventually starts to soften markets up for another rate hike. However, beyond near term volatility, we still see shares trending higher this year helped by a combination of relatively attractive valuations, further global monetary easing and continuing moderate global economic growth.

Very low bond yields point to a soft medium term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity and low inflation.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search by investors for yield.

Capital city residential property price gains are expected to slow to around 3% this year, as the heat comes out of Sydney and Melbourne. Prices are likely to continue to fall in Perth and Darwin, but price growth is likely to pick up in Brisbane.

Cash and bank deposits are likely to provide poor returns.

The ongoing delay in Fed tightening poses further short term upside risks for the $A, particularly if the RBA does not ease rates soon. However, any further short term strength in the $A is unlikely to go too far and the broad trend is likely to remain down as the interest rate differential in favour of Australia narrows as the RBA resumes cutting the cash rate and the Fed eventually resumes hiking, commodity prices remain in a secular downswing and the $A undertakes its usual undershoot of fair value.

Eurozone shares fell 2.4% on Friday and the US S&P 500 lost 0.5% amidst mixed economic data and earnings reports and as Apple continued to weigh (falling 11% over the last week). Reflecting the weak global lead, ASX 200 futures fell 6 points or 0.1%. While strength in commodity prices helped limit the decline, it nevertheless suggests a soft start to trading for the Australian share market today.

 

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Share recovery continues

Tuesday, April 26, 2016

By Shane Oliver

Share markets mostly continued to move higher over the last week as growth fears continued to recede and the oil price managed to push another 8% higher despite the failure of OPEC and Russia in Doha to agree a production freeze. US shares only rose 0.5%, but European shares (+2%), Japanese shares (+4.3%) and Australian shares (+1.5%) played catch-up with the Australian share market almost getting back to where it ended 2015. Chinese shares fell 3.9% though on concerns that there won’t be more policy stimulus. Reflecting the “risk on” tone bond yields continued to move higher, most commodity prices rose and the $A reached $US0.78 before falling back to $US0.77. Even the iron ore price hit $US70/tonne – what happened to the global steel glut?

The ability of oil and share markets to rally despite the failure of key producers to agree an oil production freeze is a positive sign. The Doha meeting was mainly about appearances anyway with Saudi Arabia and Russia already at capacity, Iran never likely to participate and many other factors driving the rebound in oil and growth assets since the panic of earlier this year. Regardless of the Doha debacle the oil market is gradually rebalancing as global oil demand slowly climbs and other producers, including the US, are slowing supply.

While we remain of the view that the broad trend in share markets is likely to remain up, the next scare is likely to come as Fed hikes return and bond yields continue to back up, pressuring equity valuations. Markets cycling back and forth between deflation/growth scares and then higher bond yields/Fed scares has been the story of the last few years now!

The New York presidential primary victories for Hilary Clinton and Donald Trump further cement the former as the Democratic presidential candidate but still leave Trump open to challenge at the Republican convention in July. Trump needs to win 53% of remaining delegates to the convention to get a majority but so far he has only been winning 49% so a contested convention could still occur. Interestingly so far he's only been getting 38% of the popular vote at the primaries so he is still getting less than majority support. The next set of GOP primaries are on April 26, but the June 7 California primary with its 172 delegates may end up being key. So a long way to go yet.

Australia is another step closer to a July 2 double dissolution election with constitutional triggers now in place. Of course it won't be declared till just after the May 3rd Budget, but just like in 2013 when the election date was announced way in advance (albeit to be changed later) we are now in another longer than normal de facto election campaign. It's too early to talk precise policy differences between the two alternatives – but it is clear that the Labor Party will focus more on budget repair via various tax hikes (restricting negative gearing, super and the capital gains tax discount) and while the Liberal/National coalition will have a bit of that too it will mainly focus on spending restraint. However, in terms of the near term impact of the election itself the risk is that some spending decisions by households and businesses are put on hold through the election campaign - with a higher risk for long de facto campaigns like this one. Qantas has already suggested this may be happening. However, there is no clear evidence that election uncertainty effects economic growth in election years as a whole. Since 1980 economic growth in election years has averaged 3.7% which is greater than average growth of 3.2% over the period as a whole. That said, growth was below average at 2.3% in 2013 which also saw a long de facto election campaign. In terms of the share market, there is some evidence of it tracking sideways in the run up to elections but on average it has gained 4.9% in the three months after elections -  so it's good to get them out of the way.

 

It's hard to disagree with RBA Governor Glenn Steven's view that there are limits to what monetary policy can do. Monetary policy can help offset cyclical fluctuations in growth but it can't solve the so-called “secular stagnation” phenomenon. There is a role here for government in removing impediments to growth (supply side reforms of the sort the G20 summit in 2014 supposedly committed too) and encouraging investment in productive assets. The trouble for central banks though is that their mandate is to achieve certain inflation targets over time - usually around 2% - and when these look like being chronically missed on the upside or the downside they invariably have to intervene. Which is what they have been doing in recent times and why "helicopter money" (ie using printed money to directly finance government spending/tax cuts) is being talked about in some countries where other monetary policy options have been exhausted, Japan being a noticeable example. Fortunately we are a long way from that in Australia, where if inflation looks like coming in under target for a lengthy period (which is a risk now) there is still plenty of scope for conventional monetary easing.

Major global economic events and implications

US housing data was a mixed bag with falls in starts and permits but solid readings for home builder conditions and existing home sales. Other US data was also mixed with a fall in the manufacturing conditions PMI for April, but gains in home prices, leading indicators and another fall in jobless claims. March quarter earnings results showed 82% of companies beating on earnings and 59% beating on sales with 26% of S&P 500 companies having reported so far.

No surprise after its huge March effort to see the ECB on hold at its latest meeting, with President Draghi indicating  it remains ready to do more if needed. Meanwhile, the ECB's bank lending survey revealed solid growth in loan demand and the composite business conditions PMI for April remained solid.

Japan’s manufacturing PMI fell further to a weak reading of 48, possibly impacted by the recent earthquake.

Chinese property prices continued to increase in March led by Tier 1 cities. While this is consistent with other indicators of improved growth in China, it also warns of renewed measures to slow bubble fears in some Chinese cities.

Australian economic events and implications

It was a quite week on the data front in Australia. Skilled vacancies did fall in March though for the second month in a row suggesting jobs growth may start to slow but too early to read too much into this.

What to watch over the next week?

In the US, the key focus will be on the Fed (Wednesday) which is very unlikely to raise interest again rates again just yet, but may try to start warning the market that another hike is in prospect for the June or July meetings consistent with its dot plot signalling two hikes this year. Recent comments from Fed Chair Janet Yellen stressing caution in raising interest rates suggests that there is close to zero chance of a hike in the week ahead. However, market pricing of just 20% probability of a June hike and just 34% for July seem too low and the Fed may try to raise these probabilities a bit. That said the combination of risks in June around Brexit and Greek debt relief negotiations suggest the Fed may choose to avoid any hike in June.

On the data front in the US expect a gain in new home sales (Monday), a rebound in durable goods orders, continued gains in home prices but flat consumer confidence (all Tuesday), March quarter GDP growth of just 0.5% annualised (Thursday), growth in employment costs remaining low at around 2%yoy, and a slight fall in inflation as measured by the core consumption deflator for March to 1.5%yoy (both Friday). While March quarter GDP growth of just 0.5% annualised is very low just bear in mind the seasonal distortion over the last 20 years that has seen March quarter growth average just 1% annualised followed by June quarter growth of 3% on average. March quarter earnings reports will also continue to flow.

After the Fed the focus will shift to the Bank of Japan (Thursday) where there is a good chance of further easing focussed on more QE around ETFs, REITs and corporate debt and a negative lending rate to banks given recent strength in the Yen, soft growth and inflation readings and the recent earthquake. Japanese data for inflation, household spending and industrial production will also be released on Thursday.

Eurozone March quarter GDP (Friday) is likely to show growth of 0.4%qoq, economic confidence data (Thursday) is expected to show a slight improvement after slipping in March and inflation is likely to have remained low in April (Friday).

In Australia, the focus will be on March quarter CPI inflation (Wednesday) which is expected to show an increase of just 0.3% quarter on quarter or 1.8% year on year as lower petrol prices and ongoing weak pricing power offset seasonal increase in prices for health and education. The underlying measures of inflation are expected to rise by 0.5% qoq or 1.9% yoy. Inflation continuing to run at or below the low end of the RBA’s target zone is one reason why we expect another RBA rate cut this year but it would need to be significantly weaker than expected to drive a May rate cut. Data for export and import prices, producer prices and credit will also be released.

Outlook for markets

Expect short term share market volatility to remain high as we head into May (“sell in May and go away, come back on St Leger’s Day”) and the Fed eventually starts to soften markets up for another rate hike. However, beyond near term volatility, we still see shares trending higher this year helped by a combination of relatively attractive valuations compared to bonds, further global monetary easing and continuing moderate global economic growth.

Very low bond yields point to a soft medium term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity, weak commodity prices and low inflation. Bonds in higher yielding countries like Australia, the US and China are relatively attractive.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search by investors for yield.

National capital city residential property price gains are expected to slow to around 3% this year, as the heat comes out of Sydney and Melbourne. Prices are likely to continue to fall in Perth and Darwin, but price growth is likely to pick up in Brisbane.

Cash and bank deposits are likely to continue to provide poor returns, with the RBA expected to cut the cash rate to 1.75%.

The ongoing delay in Fed tightening and stronger data in Australia pose further short term upside risks for the $A, possibly up to $US0.80. However, any further short term strength in the $A is unlikely to go too far and the broad trend is likely to remain down as the interest rate differential in favour of Australia narrows as the RBA eventually resumes cutting the cash rate and the Fed eventually resumes hiking, commodity prices remain in a secular downswing and the $A undertakes it’s usual undershoot of fair value.

Eurozone shares fell 0.3% on Friday, but the US S&P 500 was flat as gains in energy and bank shares offset falls in tech stocks. Despite the flat US lead, ASX 200 futures gained 26 points or 0.5% helped by a further rise in energy and metal prices.

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The ECB signals further monetary easing

Pressure mounts on the RBA

The great rebound

US Congress showdown to grip markets

US rate hike expectations shift to 2016

Rough ride ahead

Falling dollar to provide boost for economy

From goodbye to good buy

Is this 1997-98 all over again?

Reporting season so far

Cost cutting focus of earnings reports

The week in review and what's ahead

Global focus returns to the US

Is the short-term correction over?

Uncertain times

Volatility to continue, but bull market not over yet

The RBA's clear easing bias is back

Greek negotiations drag on

RBA not expected to cut...yet

US GDP and Eurozone confidence

What's happening at the Fed?

The lessons of the last Budget

What to watch over the next week

The Fed is the focus

A full week of US earnings results

What to watch over the next week

What to watch over the next week?

The economic week ahead

All eyes on the Fed

Shares at risk of a correction

What to watch over the next week

What to watch over the next week?

Earnings numbers and the week ahead

What to watch over the next week?

What to watch over the next week

What to watch over the next week?

What to watch

A list of lists for the economy and shares

What to watch this week

What does the oil price plunge mean for you?

Summer reads – the economists’ favourites

Where will markets head this week?

Investment markets and key developments

Weekly economic and market update

Global currency gyrations and the Australian dollar

Australian house prices – a bit too hot in parts

The latest Ebola outbreak – implications for investors

Why I love dividends and you should too

Investment markets and key developments over the past week

Weekly market and economic update: 28 July 2014

Investment markets and key developments over the past week - 25 July 2014

The power of compound interest - an investor's best friend

Investment markets and recent key developments

Abenomics: good for Japan, good for investors and good for Australia

Investment markets and key developments over the past week

The bond rally, secular stagnation and now Iraq

Europe continues to reflate

The structural challenges facing Australia

Australia’s March quarter GDP growth

Investment markets and key developments over the past week

India getting back on track

Investment markets and key developments over the past week

The US economy, the Fed and interest rates

21 great investment quotes

Weekly economic and market update

Crash calls for shares

Australian housing to the rescue – but is it too hot?

Common myths and mistakes of investing

Weekly market and economic update

The critical role of asset allocation for investors

The Australian economy – looking beyond the gloom

Investment markets and key developments over the past week

The US reinvents itself, again!

Investment markets and key developments over the past week

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