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

What to watch over the week

Monday, December 19, 2016

By Shane Oliver

The past week saw share markets have a few wobbles in response to a somewhat more hawkish-than-expected Fed. European shares (up 1.7%) and Japanese shares (up 2.1%) continue to benefit from falls in the Euro and Yen along with good economic data too. Against this, US shares fell 0.1% (not helped by reports that a Chinese naval vessel had seized a US underwater drone), Australian shares fell 0.5% and Chinese shares lost 4.2% (not helped by the People’s Bank of China continuing to tighten liquidity and macro prudential controls). Thanks largely to the Fed’s more hawkish message, US bond yields continued to push higher, as did the $US. Commodity prices were mixed and the $A fell in response to the rising $US.

The more hawkish than expected Fed

Fed undertakes a somewhat hawkish hike. No one can claim surprise that the Fed hiked its key Fed Funds rate by 0.25% to a range of 0.5-0.75%. It had been well flagged and was easily justified by economic conditions. What surprised some though was a shift up in the median “dot plot” of Fed meeting participants’ interest rate expectations from two to three rate hikes in 2017 suggesting a more hawkish bias at the Fed and this drove a "risk off" reaction in markets.

There is a danger in making too much of this, as a year ago, the dot plot pointed to four hikes in 2016 and we only got one, so it’s hardly reliable and the post meeting statement and Fed Chair Yellen's comments were benign, but it does seem that the Fed is turning from somewhat dovish to somewhat hawkish. With the Fed at, or close to, meeting its objectives and fiscal stimulus, on the way we are also allowing for three rate hikes in 2017. 

Source: AAP

However, it’s way too early for US monetary tightening to be a cyclical negative for shares and growth assets, as monetary policy is still very easy and we are long way from any cyclical excess that presages an economic slowdown or recession. Meanwhile, the strong $US will continue to act as a brake on the Fed getting too aggressive in raising rates.

Although its early days, reports regarding the seizure of a US underwater drone in the South China Sea coming on the back of Donald Trump appearing to challenge the One China policy and his views on trade potentially signal a further rise in US-China tensions in 2017. While it should ultimately end OK, it could cause a bit of financial market volatility along the way.

What about Italy?

If you’re wondering what happened to Italy after the No vote and the PM resigned … basically a new government was formed, led by the same party (the Democratic Party) backed by the same coalition and with the same policies (except Senate reform). Only the PM and a few ministers have changed. So, an early election has been averted, and they may hang in there till the next elections are due in 2018. The next big event in Europe will be the elections in the Netherlands in March, where the Eurosceptic Party for Freedom may do well, but not nearly enough to form government.

India’s demonetisation coming to Australia?

It has been reported that the Government is considering removing the $100 note to crackdown on the cash economy. Of course, you won’t see your $100 bills become worthless, but to convert them to smaller denominations you may have to deposit them in a bank ... at which point the tax office could raise questions if there is a lot of them. It’s understandable the Government is upset at missing out on tax because of the cashless economy. But, such a move may not go down well with some who legitimately earned and paid tax on their notes but just don’t trust banks. India’s demonetisation experience also highlights that it runs the risk of short term economic disruption – but this should be much smaller in Australia where the cash economy is estimated to be around 1.5% of GDP compared to much more in India.

Major global economic events and implications

US economic data was mostly strong. Industrial production fell, retail sales were weaker-than-expected and housing starts fell 19%. But the weak retail sales followed two very strong months and the fall in housing starts followed a 27% gain in October and reflects volatility in multifamily starts. Meanwhile, gains in regional manufacturing indices and continued strength in the Markit manufacturing conditions PMI point to stronger manufacturing going forward. Small business optimism also rose strongly in November, and home builder’s conditions rose to their highest since 2005. And jobless claims remain low. Inflation readings were mixed, with a stronger rise in producer prices, but falls in import prices as the strong $US hit and core CPI inflation remained in the range it’s been in for the last year.

Eurozone business conditions PMIs remained solid in December, and continue to point to some acceleration in growth. 

Japan’s Tankan business survey and December manufacturing PMI showed improved conditions for manufacturers.

Chinese economic data for November was stronger-than-expected, with a pick-up in retail sales, industrial production and total credit suggesting that December quarter GDP growth may have picked up a bit from the 6.7% year-on-year pace.

Australian economic events and implications

Australian data was a mixed bag, with a fall in business conditions and consumer confidence, but a slight rise in business confidence and stronger jobs growth. A fall in consumer confidence was to be expected in December, following the weak September quarter GDP news, but the November jobs data was surprisingly healthy.

Yes, unemployment rose, but this was all due to higher labour force participation and monthly jobs growth was strong for the second month in a row with two months of strong full jobs growth. Leading jobs indicators such as job ads and vacancies point to reasonable jobs growth ahead.

Finally, Australians continue to see paying down debt and bank deposits as the wisest place for savings and remain sceptical of shares. The latter tells us that the share market is a long way from being over loved, which is a good sign from a contrarian perspective. Interestingly, real estate remains out-of-favour too.

Source: Melbourne Institute, AMP Capital

What to watch over the next week?

In the US, expect to see continued strength in November’s Markit services conditions PMI (Monday), a fall back in existing home sales (Wednesday), modest growth in underlying durable goods orders and personal spending, with inflation in the core private consumption deflator remaining unchanged at 1.7% year-on-year and home prices continuing to rise (all Thursday) and a bounce back in new home sales (Friday).

The Bank of Japan (Tuesday) is unlikely to make any major changes to monetary policy given the open-ended quantitative easing until it exceeds its inflation target that it adopted in September.

In Australia, the main focus will be the Mid-Year Economic and Fiscal Outlook budget update (Monday) where there is a risk of a further downgrade to the outlook for the budget deficit as lower wages growth offsets the beneficial impact of higher commodity prices. Quite how this pans out is dependent on what assumptions the Government adopts regarding key commodity prices relative to wages, but on balance we anticipate little change to the $37bn budget deficit projected in May for this financial year, but $10bn or so added to the deficit in the subsequent three years, but with the Government still projecting a return to a wafer-thin surplus by 2020-21. In terms of economic assumptions for this financial year, expect real GDP growth to be revised down to 2.25% (from 2.5%) and wages growth is likely to be revised down to 2% (from 2.5%). To offset the further deficit blow out, the Government is likely to announce various savings (eg, abolition of the Green army, more tax revenue from the cash economy). Overall, the MYEFO may not be enough to trigger a rating downgrade immediately, but I think whether it’s in the week ahead, or after the May Budget, a downgrade is just a matter of time. This would be a huge psychological blow to Australia, but I doubt that it will have a lasting impact on bond yields or borrowing costs. 

Source: Australian Treasury, AMP Capital

Meanwhile, the Minutes from the last RBA Board meeting (Tuesday) are likely to confirm that the RBA retained a neutral bias on rates. But these Minutes will be very dated, given the subsequent news of a fall in September quarter GDP.

Outlook for markets

Shares remain overbought and are vulnerable to a short-term pullback with potential triggers being uncertainty about what Donald Trump will do, US-China tensions, the sharp back up in bond yields and the strong $US. However, any correction may not come until the New Year given normal seasonal strength (the Santa rally) into year end. And we see share markets trending higher over the next 12 months helped by okay valuations, continuing easy global monetary conditions, fiscal stimulus in the US, moderate economic growth and the shift from falling to rising profits for both the US and Australia. 

Sovereign bonds are now very oversold and due for a short term pullback in yield. This is particularly the case in Australi, where 10-year bond yields at 2.9% look out of whack with the likelihood that the RBA will cut rates again next year, or at the very least, won’t be raising them until 2018 at the earliest. But on a medium-term view still, low bond yields point to a poor return potential from bonds and the abatement of deflationary pressures as commodity prices head up, the gradual using up of spare capacity and a shift in policy focus from monetary to fiscal stimulus indicates that the long-term decline in yields since the early 1980s is probably over. So expect the medium-term trend in bond yields to be up. 

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors, but this demand will wane as bond yields trend higher over the medium term. 

Dwelling price gains are expected to slow, as the heat comes out of Sydney and Melbourne and as apartment supply ramps up, which is expected to drive 15-20% price falls for units in oversupplied areas into 2018.

Cash and bank deposits offer poor returns. 

A shift in the interest rate differential in favour of the US as the Fed remains on its path to hike rates should see the long term trend in the $A remain down.

Eurozone shares rose 0.3% on Friday, but the US S&P 500 fell 0.2% following reports that a Chinese naval vessel had seized a US underwater drone in the South China Sea. Following the mixed global lead, ASX 200 futures fell 0.1% on Friday night so I expect the Australian share market to open down around 5 points on Monday morning.

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Bad news is good news for the stock markets

Monday, December 12, 2016

The past week saw most major share markets rise with US shares up 3.1% to a new record high, a 5.6% gain in Eurozone shares resulting in a clear technical breakout led by banks, Australian shares gaining 2.1% taking them to near their August high and Japanese shares up another 3.1%. The main drivers have been continued good global economic data, the prospect of help for Italian banks, a dovish ECB and expectations of lower interest rates in Australia’s case. Bond yields mostly rose and commodity prices were mixed. Despite a stronger $US the $A was little changed.

Bad news is good news. It seems that ever since the Brexit hoopla seemingly bad outcomes for share markets have seen a brief dip in markets – often in our time zone – only to be followed by a surge higher. This has been the story with Brexit, Donald Trump’s election, the Italian “No” vote and even Australia’s recent poor growth news. There are several reasons for this seemingly perverse response.

First, many share markets had 20% plus falls into earlier this year so bad news was sort of factored in.

Second, many of these events have seemed less negative than feared once they transpired – Britain and more importantly Europe did not collapse after the Brexit vote, many of Donald Trump’s policies are positive for growth and hence share markets and even though Italy voted “No” there is a long way to go to get to an Itexit.

Third, the macro economic backdrop globally – with rising business conditions PMIs, still easy monetary policy and the end of the earnings recession in several key markets – are positive in contrast to say a year ago.

Fourthly, each event has held out the prospect of more pro-growth economic stimulus.

Finally, December is one of the strongest months of the year – see next chart. Normally the Santa rally doesn’t come till mid-December but he seems to have arrived early this year!

A lesson in all this is to turn down the noise – the coverage around Brexit, etc, was huge but investors would have been better off doing nothing but sticking to their long turn strategy. Or if you are going to do anything be contrarian & buy the dips.

Source: Bloomberg, AMP Capital

The Italian “No” vote is a case in point. It was no more a sign of increased support for the populist anti-Euro Five Star Movement than a “No” vote to a similar neutering of our Senate in Australia would signal support for One Nation. And in any case a lot will have to occur before Italy leaves the Eurozone, if at all. Meanwhile, Austrians voted against their anti-Euro far right presidential candidate in greater numbers than was the case pre-Brexit. I remain of the view that a break-up of the Eurozone is unlikely and that the various European elections in the year ahead could simply prove to be buying opportunities.

Meanwhile, the ECB provided more support for financial markets. While it cut its quantitative easing program to €60bn a month it extended it to the end of 2017 which was more than expected and President Draghi’s comments were dovish. The extension takes it right through a period of political risk associated with key European elections next year.

Major global economic events and implications

US economic data remained solid with the non-manufacturing ISM business conditions index rising to a strong 57.2, job openings and hiring remaining strong, jobless claims remaining low and rising consumer confidence.

Meanwhile, Donald Trump’s appointments are continuing to be market friendly with his pick for head of the Environmental Protection Agency consistent with a roll back of EPA regulations and his choice of a China friendly ambassador to China could help soothe relations with China. Meanwhile, although Trump’s tweets have created some angst the trick as borrowed from US political commentator Salena Zito is to treat his comments seriously but not literally.

While German industrial production was soft in October, a 4.9% mom surge in factory orders points to a rebound ahead and a broader pick up in German growth.

Japan wages growth remains weak but an economic sentiment rose to levels last seen before the sales tax hike.

In China, export and import growth improved far more than expected and producer price inflation rose further to 3.3% yoy adding to the message of improvement seen in other Chinese economic indicators.

Australian economic events and implications

As feared the Australian economy contracted in the September quarter – with broad based weakness across housing, business investment, public demand, net exports and consumer spending – but here are seven reasons why it’s unlikely to signal the start of a recession.

First, it looks to be a bit of payback for stronger than expected growth over the year to the June quarter.

Second, the fall in housing and non-dwelling construction looks to have been partly bad weather related which should reverse with approvals for both pointing up in the short term.

Third, public capital spending projects point to a rebound in public demand.

Fourth, the boom in resource export volumes has further to go as various mining and gas projects complete.

Fifth, recent retail sales data point to a strengthening in consumer spending.

Sixth, while the drag from unwinding mining investment has further to run its impact is declining as it falls as a share of GDP and it should reach a bottom in the next year or so.

Finally, it doesn’t feel like the start of a recession. The traffic is jammed up, shopping centre’s seem full and there is not the sense of foreboding seen in 1989-1990 that went into the last recession (yeah – I was around back then!). Sure it’s a recession in WA but that’s been the case for a while now and is a direct result of the mining investment slump, but that’s not the whole of Australia.

In other data the trade deficit was worse than expected, housing finance fell but continues to bounce back for investors, ANZ job ads remain solid and the AIG’s services PMI rose which along with the already reported rise in the manufacturing PMI adds to confidence growth has picked up again.

But while a recession is unlikely, underlying growth looks like its running below the RBA’s assumed circa 3% pace which along with chronic low wages growth means inflation is likely to be weaker than it expects too. This is also not a good time for the banks to be raising mortgage rates (as they have started to lately with the high risk standard variable rates will go up too) and the $A remains too high. As such, we remain of the view that the RBA will cut rates again next year. It could come as early as February.

Finally, New Zealand continues to impress. Its latest budget update showed an ongoing surplus despite its latest earthquake whereas our budget updates seem to just go from bad to worse and we seem to go from one silly debate to another – eg whether to levy a back packer tax at 15% or 13% or around in circles over carbon pricing. No wonder New Zealanders are going back!

What to watch over the next week?

In the US, after a full 12 months since its first rate hike the Fed (Wednesday) will finally raise its key interest rate again by another 0.25%. With this fully priced in the main focus will be on whether it’s a hawkish hike or dovish hike so the key will be whether Janet Yellen continues to refer to “gradual” rate hikes and how aggressive the dot plot of meeting participants rate hike expectations for 2017 are. Our expectation is that the Fed will stick to the gradual language and the September dot plot of two hikes for next year but indicate that it’s waiting to see how significant fiscal stimulus will be under Donald Trump. 

On the data front in the US expect continued solid November retail sales growth but a slight fall in industrial production (both Wednesday), a slight rise in core CPI inflation to 2.2% yoy and continued strength in the NAHB home builders’ index and manufacturing condition PMI (all Thursday) and some fall in housing starts after October’s 25% surge (Friday).

In the Eurozone expect the December business conditions PMIs (Thursday) to remain solid.

In Japan the quarterly Tankan business survey (Wednesday is expected to show an improvement.

Chinese activity data for November (Tuesday) is expected to show unchanged growth in industrial production of 6.1% yoy but a pick-up in retail sales growth to 10.4% yoy.

In Australia, ABS house price data (Tuesday) is expected to show a gain of 2.5% for the September quarter consistent with private sector surveys already released, the NAB survey (also Tuesday) is expected to show business conditions and confidence in November remaining above average but consumer confidence data (Wednesday) may show a dip on the back of the weak September quarter GDP news. Jobs data (Thursday) are expected to show a 25,000 gain in employment and unemployment remaining at 5.6% but the focus is likely to remain on the full time versus part time break up.

Outlook for markets

Shares remain overbought and are vulnerable to the Fed meeting in the week ahead. However, we continue to anticipate shares to be higher into year-end as seasonal strength continues to kick in and see share markets trending higher over the next 12 months helped by okay valuations, continuing easy global monetary conditions, fiscal stimulus in the US, moderate economic growth and the shift from falling to rising profits for both the US and Australia.

Sovereign bonds are now very oversold and due for a short term pullback in yield. But still low bond yields point to a poor medium term return potential from them. The abatement of deflationary pressures as commodity prices head up, the gradual using up of spare capacity and a shift in policy focus from monetary to fiscal stimulus indicates that the long term decline in yields since the early 1980s is probably over. Expect the trend in bond yields to be up.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors though as these two asset classes never fully adjusted to the full decline in bond yields.

Dwelling price gains are expected to slow, as the heat comes out of Sydney and Melbourne and as apartment supply ramps up which is expected to drive 15-20% price falls for units in oversupplied areas into 2018.

Cash and bank deposits offer poor returns.

A shift in the interest rate differential in favour of the US as the Fed remains on its path to hike rates should see the long term trend in the $A remain down.

Eurozone shares gained 0.4% on Friday and the US S&P 500 index rose 0.6%. The positive global lead helped by a rise in the oil price saw ASX 200 futures rise 0.4%, so I expect the Australian share market to open up by around 20-25 points on Monday morning.

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Will interest rates rise in 2017?

Monday, December 05, 2016

By Shane Oliver

The past week saw Japanese and Chinese shares both gain another 0.2%, but US and European shares fall 1% and Australian shares fall 1.2% as they had a bit of a consolidation along with the $US (which fell 0.8%), after the post US election rally led to overbought positions. However, energy shares and the oil price (up 12%) got a huge boost after OPEC agreed on a production cut. Metal prices and the iron ore price slipped a bit but the $A still rose slightly as the $US fell. Bond yields were mixed – up in the US and Australia, but down in Europe.

After a “yes they will, no they won't” soap opera, OPEC agreed on an oil production cut of 1.2 million barrels a day. While stronger than talked about in September, this was made necessary by a ramp up in production since then. The cut adds to confidence that we have seen the low in oil prices and that deflationary forces are in retreat. So good news for energy producers and central banks. But there is a danger in getting too excited.

Around $50/barrel is where the median shale oil producer is economic, and so shale production will start to ramp up again (the US rig count is already well up from its lows) and it’s questionable whether OPEC discipline will really hold … so I am sceptical that the oil price will go too high. Maybe $55 or $60 tops. Inflation is already picking up as the 2014 to early 2016 oil price plunge drops out, but so far, the flow on to core inflation has proven to be muted. Don’t forget that the oil price is still less than half 2013-14 levels. For Australian petrol prices, the OPEC cut might add 5 cents a litre at the bowser but that will be lost in normal day-to-day price volatility.

Image: OPEC, AAP

China appears to be seeing another one of its periodic policy tightening phases, with increasing measures to cool the hot property market, a crackdown on capital outflows to ease downwards pressure on the Renminbi, tighter monetary conditions, and measures around shadow banking and commodity markets. The Chinese share market may be a beneficiary though to the extent capital outflows are limited and need to find a home domestically and it’s not seen as too hot.

Major global economic events and implications

US data remained strong, with September quarter GDP growth revised up to 3.2%, consumer confidence rising sharply in November, the ISM manufacturing conditions index rising further in November, home prices continuing to rise, construction spending up and employment up solidly in November and unemployment down to 4.6%. The Fed remains on track for a December rate hike, particularly with the fall in unemployment indicating less slack in the economy. However, a fall back in wages growth in November to 2.5% year-on-year will likely keep rate hikes on a gradual path for now, until the Fed gets more clarity around Donald Trump’s stimulus plans. Meanwhile, Trump’s picks for various cabinet positions including Treasury secretary are adding a bit to confidence in his administration, such that the dial is still pointing to Trump the pragmatist as opposed to Trump the populist.

In the Eurozone, economic sentiment moved higher in November and bank lending accelerated a touch, pointing to slightly stronger economic growth. Unemployment even fell to its lowest since 2009. Meanwhile, CPI inflation rose as the impact of the plunge in oil prices continues to fall out, but core inflation remains stuck at a low 0.8% year-on-year.

Japanese data was better-than-expected, with continuing jobs market strength, stronger-tha- expected household spending, a continuing upswing in industrial production and gains in housing starts and construction orders.

Chinese business conditions PMIs were better-than-expected and remain consistent with good growth. 

Indian September quarter GDP growth accelerated to 7.3% year-on-year from 7.1%. Growth may slow in the current quarter because of “demonetisation”, but the November manufacturing conditions PMI suggests only a moderate impact.

Australian economic events and implications

Weak business investment data both for the September quarter and intentions for the current financial year, along with another sharp fall in building approvals, added to a sense of near term economic gloom regarding Australian economic growth. As we noted a week ago, there is a significant risk that September quarter GDP growth will be negative – thanks to weak retail sales volumes, a fall in dwelling investment, a continuing fall in business investment, and weak net exports. While a continuing decline in mining investment is no surprise, the failure to see stronger non-mining investment is disappointing.

However, there is no reason to get too gloomy. Weak and possibly negative September quarter GDP growth looks like payback for stronger than expected GDP growth over the year to the June quarter of 3.3%. And looking forward, the ramp up in resource export volumes has further to go, there is still a huge pipeline of housing activity yet to be completed so home building is likely to rebound in the short term, strengthening approvals for non-dwelling construction are a positive sign, the drag from mining investment is fading as it reduces in importance, and its likely to be close to a bottom in the next 12-18 months (see chart), recent retail sales data have improved (with three months in a row of solid growth up to October suggesting a consumer bounce back in the December quarter), another rebound in the manufacturing conditions PMI for November suggests that the September quarter growth soft patch may be over, and the rebound in commodity prices tells us that the income recession in Australia is over. 

 

Source: ABS, AMP Capital

Rate hike in 2017?

However, recent soft data highlights that it’s way too early to be talking about a 2017 RBA rate hike.

In fact, given the downside risks to near-term growth, and inflation along with the $A remaining too high, we remain of the view that the RBA will cut the cash rate again during the first half of 2017.

Just finally, home price momentum remained solid in November according to CoreLogic – except in Melbourne where unit prices lost 3.2%. The apartment supply surge is starting to impact in that city and it will likely spread to others next year.

What to watch over the next week?

Reaction to the Italian Senate referendum on December 4 will no doubt impact investment markets early in the week. While confirmation of a “No” vote (as the polls are suggesting) will add to uncertainty about the Italian government and its banks and maybe further fuel fears about a “break-up” of the Eurozone, a lot will have to occur before Italy leaves the Eurozone, if at all. An early Italian election is unlikely to occur, and even if there is, the populist Five Star Movement (5SM) is unlikely to win unless it softens its anti-Euro stance. Meanwhile, if the “Yes” vote wins, Italy’s economic woes will remain (and ironically it would increase the risk that 5SM could form government at some point). So the referendum is unlikely to settle anything either way. More broadly, the Eurozone is likely to continue to hang together and bouts of market turmoil driven by break-up fears should be seen as buying opportunities.

After the Italian vote, all eyes in Europe will shift to the ECB meeting on Thursday which is expected to announce a six-month extension of its quantitative easing program beyond its current expiry of March 2017 and some changes to enable it to buy a wider universe of bonds. Continuing moderate growth and sub-par inflation along with issues around Italy and Italian banks are likely to be the main drivers with the back-up in bond yields giving the ECB a bit of leeway. It may also try and inject a bit of flexibility into its QE program to allow it to speed up and slow individual country bond buying as justified. 

In the US, expect the non-manufacturing conditions ISM index (Monday) to remain strong, the trade balance (Tuesday) to deteriorate and labour market indicators for hiring and vacancies (Wednesday) to remain solid.

Chinese October trade data (Thursday) is expected to show continued softness in exports and imports and a further rise in both consumer and producer price inflation (Friday).

RBA meeting

In Australia, the RBA is expected to leave rates on hold on Tuesday. While recent data points to soft September quarter GDP growth to be released on Wednesday, this is unlikely to be enough to move the RBA to cut rates given recent upbeat commentary on the economy from both Governor Lowe and Assistant Governor Kent.

However, as noted above, we remain of the view that the RBA will cut rates again in the first half of next year, reflecting downside risk to both growth and inflation. 

On the data front in Australia, expect September quarter GDP growth (Wednesday) of just 0.2% quarter-on-quarter or 2.5% year-on-year driven by weak business investment, retail sales, housing investment and trade with a high risk of a fall in GDP. September quarter data for production, profits and inventories (Monday) and net exports and public demand (Tuesday) will help fine tune September quarter GDP forecasts. Expect the surge in coal prices to have led to a further collapse in the trade deficit (Thursday) and housing finance (Friday) to fall.

Outlook for markets

Shares remain overbought and are vulnerable to the outcome of the Italian Senate referendum, the upcoming ECB and Fed meetings and to any further near term rise in bond yields. However, we anticipate shares to be higher by year end as seasonal strength kicks in - the “Santa rally” normally gets underway from around mid-December - and see share markets trending higher over the next 12 months helped by okay valuations, continuing easy global monetary conditions, a shift towards fiscal stimulus in the US, moderate economic growth and the shift from falling to rising profits for both the US and Australia. 

Sovereign bonds are now very oversold and due for a short term pullback in yield. But still low bond yields point to a poor medium term return potential from them. The abatement of deflationary pressures as commodity prices head up, the gradual using up of spare capacity and a shift in policy focus from monetary to fiscal stimulus indicates that the long term decline in yields since the early 1980s is probably over. Expect the trend in bond yields to be up.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors though as these two asset classes never fully adjusted to the full decline in bond yields. 

Dwelling price gains are expected to slow, as the heat comes out of Sydney and Melbourne thanks to poor affordability, tougher lending standards and as apartment supply ramps up which is expected to drive 15-20% price falls for units in oversupplied areas into 2018.

Cash and bank deposits offer poor returns. 

A shift in the interest rate differential in favour of the US as the Fed remains on its path to hike rates should see the long term trend in the $A remain down.

Eurozone shares fell 0.5% on Friday but the US S&P 500 was flat after the mixed US jobs report (which showed solid payroll growth and lower unemployment but lower labour force participation and slower wages growth). However, ASX 200 futures gained 0.4% possibly on expectations that Fridays 1% decline in the ASX 200 was overdone and as the oil price advanced another 1% on Friday. This is pointing to a 20 point gain in the Australian share market at the open on Monday. However, this could be affected by reaction to the outcome from Sunday’s Italian referendum.

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What to watch over the next week

Monday, November 28, 2016

By Shane Oliver

The past week saw the rally in shares continue to be helped by good global data, rising commodity prices and ongoing optimism regarding President elect Trump’s stimulus plans. US shares rose 1.4%, Eurozone shares rose 0.9%, Japanese shares rose 2.9%, Chinese shares rose 3% and Australian shares gained 2.8%. The main drag though is the continuing rise in the $US which has broken out to its highest level against an average of major currencies since 2003.

Despite this, commodity prices rose, making the latest bout of $US strength more positive than seen in 2014. Higher prices for bulks, metals and energy saw resources shares lead the charge higher in Australian shares over the last week. Despite the rising $US, the $A rose, helped along by higher commodity prices. Bond yields continued to rise in the US and Australia. 

Is Europe different?

Brexit, Trump, Le Pen … or is Europe different? Naturally, after the recent experience in the UK and US, which is indicative of a resurgent nationalist backlash against the pro-globalisation establishment, there is a fear that Europe will go the same way. But there are several reasons for thinking that Europe is different – that a populist driven break up won’t happen.

First, Europe does not have the same issues with inequality that has driven the "leftist" backlash in the UK and US. It has always been well to the left of Anglo countries.

Second, the maximum risk point in the Eurozone was arguably just after the Eurozone debt crisis a few years ago when austerity and unemployment were at their peak.

Third, despite the media excitement, the increase in support for the Euro-sceptic populists following Brexit, Trump, etc, has not really been overwhelming. Support for Le Pen and the National Front in France has been stuck around 25%. The Five Star Movement in Italy looks to have peaked in the polls and polls less than the governing party. Alternative for Deutschland only gets about 15% support.

Finally, support in mainland Europe for the EU and Euro is high. Perhaps the two main pressure points in Europe are the migration crisis and austerity - but the migration crisis is abating and austerity looks to be over with the European Commission even recommending recently that member countries adopt a more expansionary stance. Risks are high though and the December 4 Austrian presidential election and Italian Senate referendum could add to fears about a break up. But the evidence suggests that Europe is not the same as the UK and the US and that bouts of share market weakness on Eurozone breakup fears should be seen as buying opportunities.

Australia's soap opera

The soap opera about Australia’s AAA sovereign rating is back on again, but does it really matter? While the surge in bulk commodity prices should boost corporate tax revenue this looks like being offset by lower personal tax collections due to lower wages growth, so yet another budget blow out is possible. Meanwhile, S&P has Australia on negative outlook and has warned of a downgrade if there is any further delay in return to balance by 2020-21. Given the continuous delays of recent years and Australia’s continuing dependence on foreign capital, the odds of a downgrade are high. But would it matter?

First, based on other countries that have been downgraded it’s 50/50 as to whether borrowing costs would actually rise in response to a downgrade. Italy and Spain have lower ratings than Australia and yet have lower borrowing costs. And in any case, if mortgage rates do rise in response to a downgrade, the RBA can always cut the official interest rate in order to bring them back down to where it wants them. In fact, the main blow from a downgrade would be what it tells us about the deterioration in the quality of economic policy making in Australia.

Mortgage rates

Australian mortgage rates on the way back up? The past week has seen several lenders raise fixed rate mortgage rates. This is a natural reaction to the back up in bond yields which drive the funding costs for fixed rate mortgages. Major bank variable rates are at risk of out of cycle increases but it’s hard to see them rising significantly any time soon as we don’t see the RBA raising the cash rate until 2018 (see below). 

Major global economic events and implications

US economic data remained solid. The Markit manufacturing conditions PMI, consumer sentiment, durable goods orders and existing home sales all rose more than expected and the services PMI remained strong. December quarter GDP growth is tracking around 3% annualised and the US money market is pricing in a 100% probability of a December Fed rate hike.

Eurozone business conditions PMIs also rose further in November and are tracking at levels consistent with a pick-up in GDP growth to around 2%. Consumer confidence also rose. 

Japan’s manufacturing PMI slipped but remains well up from mid-year lows, and inflation rose but remains weak. 

Australian economic events and implications

An upbeat RBA versus a possible slump in September quarter GDP growth ... what gives? Assistant RBA Governor Kent painted a relatively upbeat view of the economic outlook similar to that portrayed by Governor Lowe the week before. By contrast, September quarter construction activity fell much more than expected and along with likely weak net export volumes and soft retail sales points to weak, possibly even slightly negative, September quarter GDP growth, which if reported in early December will no doubt reinvigorate concerns about the Australian economy. However, while the RBA may be a bit too upbeat, I wouldn’t read too much into likely soft September quarter GDP, because it will be payback for much stronger-than-expected growth over the year to the June quarter of 3.3%.

And looking forward, the ramp up in resource export volumes has further to go, approvals data point to a bounce back in dwelling construction and strengthening non-dwelling investment, mining investment is getting close to a bottom with engineering work back to around its long term trend (see chart), recent retail sales data have improved and the rebound in commodity prices tells us that the income recession is over. Given the possible September quarter soft patch in growth and downside risks in inflation we are still allowing for one more interest rate cut next year, but overall growth is likely to be around 3% in 2017 which will help set the scene for a likely RBA rate hike in 2018.

What to watch over the next week?

  • OPEC, US payrolls, the Austrian presidential election and Italian Senate referendum and Australian capex data will likely be the main focus points in week ahead.
  • It’s a close call, but our assessment is that OPEC (Wednesday) will probably reach agreement on a production cut as inventories are rising, Iran is at maximum capacity and Saudi Arabia wants to re-establish its position as the leader of OPEC. This should help the oil price but don't get too excited - it may not get much higher as US shale oil production looks like it’s ramping up again, lighter energy sector regulation under a Trump administration will likely also add to US oil production and OPEC discipline around any cut will be debatable. But it will add to the case that it’s bottomed.
  • In the US, expect a solid rise in the ISM manufacturing conditions index (Wednesday) for November and solid payroll employment growth (Friday) of 180,000 to support expectations for another Fed rate hike in December. The jobs data is likely to show unemployment unchanged at 4.9% and wages growth holding at 2.8%. Meanwhile, expect a rise in consumer confidence and further gains in home prices (both Tuesday), solid personal spending but the core personal consumption deflator remaining around 1.8% year-on-year and little change in pending home sales (all Wednesday). 
  • In the Eurozone, all eyes will be on the Austrian presidential election and Italian senate referendum to be held on Sunday December 4. Opinion polls point to a victory by the right wing Eurosceptic candidate in Austria and a “No” vote in Italy both of which will lead to an increase in Eurozone break up fears. But there will be a long way to go before either country will have a referendum on Eurozone membership (if indeed they do) and as we have seen with Greece a majority of the population support staying in the Euro. On the data front, economic confidence indicators (Tuesday) are expected to show further strength and core inflation (Wednesday) is likely to have remained around 0.8% year-on-year. 
  • Japanese jobs data for November is likely to have remained strong but household spending (both Tuesday) is expected to have remained soft and industrial production (Wednesday) relatively subdued.
  • Chinese manufacturing PMIs (Thursday) for November may slip back a bit but are likely to remain in a rising trend.
  • In Australia, September quarter business investment data (Wednesday) is expected to show continued mining driven weakness but with signs that mining investment is getting close to the bottom and that non-mining investment plans may be improving. Meanwhile, expect a bounce in building approvals and continued moderate credit growth (both Wednesday) and a 0.2% gain in October retail sales (Friday).

Outlook for markets

Shares are now overbought and due for a pause and event risk could cause short term volatility with policy uncertainty remaining high in the US, Eurozone break up risks coming back into focus with the Italian Senate referendum and Austrian presidential election re-run and ECB and Fed meetings in December. Bond yields could also see more upside in the short term. However, we anticipate shares to be higher by year's end as seasonal strength kicks in (the “Santa rally”) and see share markets trending higher over the next 12 months helped by okay valuations, continuing easy global monetary conditions, a shift towards fiscal stimulus in the US, moderate economic growth and the shift from falling to rising profits for both the US and Australia. 

Sovereign bonds are now very oversold and due for a pullback in yield. But still low bond yields point to a poor medium term return potential from them. The abatement of deflationary pressures as commodity prices head up, the gradual using up of spare capacity and a shift in policy focus from monetary to fiscal stimulus indicates that the long term decline in yields since the early 1980s is probably over. Expect the trend in bond yields to be up.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors though as these two asset classes never fully adjusted to the full decline in bond yields. 

Dwelling price gains are expected to slow, as the heat comes out of Sydney and Melbourne thanks to poor affordability, tougher lending standards and as apartment supply ramps up which is expected to drive 15-20% price falls for units in oversupplied areas around 2018.

Cash and bank deposits offer poor returns. 

A shift in the interest rate differential in favour of the US as the Fed remains on its path to hike rates should see the long term trend in the $A remain down.

Eurozone shares gained 0.2% on Friday and the US S&P 500 rose 0.4% despite a 4.2% fall in the oil price on scepticism OPEC will reach an agreement to cut output. Despite the gains in US shares the ASX 200 futures contract was flat, perhaps weighed down a bit by the fall in the oil price, pointing to a flat start to trade for the Australian share market on Monday.

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Trump the pragmatist, or protectionist?

Monday, November 21, 2016

By Shane Oliver

The past week saw US shares gain 0.8% and Japanese shares gain 3.4% as bond yields and the $US continued to push higher as investors focussed on prospects for fiscal stimulus and deregulation under a Donald Trump presidency. However, Chinese shares were flat, Eurozone shares slipped 0.3% and Australian shares fell 0.2% after their 3.7% surge in the previous week. Emerging market shares remained under pressure from the rising $US and commodity prices were mixed. The rising $US saw the $A fall below $US0.74 which is good news for the RBA. 

Pragmatic Trump?

It’s still early days, but the past week provided a bit more evidence that we are more likely to see a pragmatic Donald Trump as president (focussed more on positive measures to boost growth - tax cuts, infrastructure spending and deregulation) rather than a protectionist populist. To be sure, some of the appointments to his team have raised question marks and some action on the trade front looks inevitable but his appointment of a Republican establishment figure as his Chief of Staff and his watering down of commitments around the Affordable Care Act, the wall with Mexico and deporting illegal immigrants suggest he is likely to be more moderate than his campaign rhetoric suggested. As such, while risks on the trade front are high, we remain of the view that his stimulatory policies on balance are likely to be neutral to positive for advanced country equities, positive for commodities, positive for the $US as the Fed is likely to tighten by more and negative for bonds and some emerging share markets (as a rising $US creates dollar funding concerns). Of particular note though:

  • The last two big cyclical surges in the $US in 1981-85 and 1997-2001 were actually good for US shares with the S&P 500 index up 50% and 80% respectively.
  • European and Japanese equities will be particular beneficiaries of a rising $US - maybe not so much Europe in the short term given short term risks around Italy and Austria (see below) but particularly Japanese shares which get the benefit of a falling Yen but are not seeing the same upwards pressure on bond yields because of the Bank of Japan's commitment to cap JGB yields at zero which in turn is amplifying downwards pressure on the Yen.
  • Upwards pressure on bond yields (made worse by an unwinding of long bond positions) and the $US is likely to pause and then become more gradual as the rise in the $US at a time when other central banks are a long way from tightening will help limit how quickly the Fed will raise rates.
  • The falling Chinese Renminbi (RMB) is a strong $US, not weak Renminbi story. Over the last week, as $US index (DXY) rose 2.3% against a basket of currencies, the RMB fell 1.2% against the $US but its trade weighted basket is basically flat. In fact, the fall in the RMB against the $US is mild compared to that of other currencies, eg. over the last week the Euro fell 2.4%, the Yen fell 3.9% and the $A fell 2.5%. So it’s not a case of China artificially devaluing their currency ahead of a feared protectionist Trump presidency. 
  • Cyclical share market sectors are likely to continue to outperform bond proxies such as REITs. 

Will President Trump replace Janet Yellen?

There is much talk he will replace her with a more hawkish “hard money” chairperson. However, she is answerable to Congress not the president and her current term does not end until the end of January 2018 (until which she has indicated she intends to stay) but by which time Trump may well conclude that it’s in his own interest to retain a more dovish Fed leader for fear that a more hawkish Fed would offset the benefits of his stimulus program via even higher interest rates, bond yields and a $US. So it’s premature to conclude he will replace Yellen.

Focus shifts to Europe

The geopolitical focus is now shifting back to Europe, with the upcoming referendum on reducing the power of the Italian Senate and the Austrian presidential election both on December 4 refocussing attention on Eurozone break up risks. Opinion polls in Austria are pointing to the election of the Euro-sceptic right wing candidate - and although the president is largely ceremonial his election could add to anxiety about the threat to Europe. Italy is more significant though - the Senate referendum coming on the back of reforms to the lower house of Italy's parliament are designed to make Italy more governable and clear the way for long needed economic reforms (just what Australia needs!)

Opinion polls are now leaning to a "No" vote. A "No" vote would probably see PM Matteo Renzi resign with fears that this will lead to an early election with the Euro-sceptic Five Star Movement (5SM) winning, calling a referendum on Italy's membership of the Eurozone which would then see Italy move to leave. As a result, bond yields in Italy have blown out on fears that at some point Italian debt will be redenominated into a less valuable currency. These fears are likely exaggerated though: the referendum's failure would just mean messy politics as normal in Italy, it's unlikely there will be an election before the due date in 2018, even if there was it’s not clear that 5SM would win (its poll support is no longer rising and its below support for the governing party) and even if it did and called a referendum on Italy's membership of the Euro a majority of Italians support staying in the Euro. That said, markets may still worry about what would happen if there is a "No" vote. So it could cause short-term volatility but I suspect another bout of share market weakness on Eurozone break up fears would prove to be yet another buying opportunity just like over the last five years. 

Major global economic events and implications

US data was mostly solid. Retail sales rose more than expected in October and were revised up for September indicating that the consumer is kicking into gear, while industrial production was soft in October regional manufacturing conditions indexes suggest little reason for alarm, solid home builder conditions and strong housing starts point to solid housing investment and jobless claims remain low. Meanwhile, headline consumer price inflation continues to rise as the impact of the fall in energy prices falls out, but producer price inflation and core CPI inflation was softer than expected. Finally, Janet Yellen's testimony provided no surprises indicating rates will likely rise "relatively soon" but that the process of rate hikes would remain "gradual". Bottom line: US growth looks to be running around 3% in the current quarter consistent with the Fed hiking rates in December, for which the money market is now attaching a 98% probability.

Eurozone GDP growth remained moderate at 0.3% quarter on quarter/1.6% year-on-year (yoy) in the September quarter as widely expected. Business conditions PMI's and confidence readings point to some pick-up in growth ahead. 

Japanese GDP growth surprised on the upside for the September quarter with strength in exports, housing investment and public spending. Last year's volatility has given way to more steady growth this year with stronger consumer spending likely to help growth going forward. 

Chinese economic activity indicators were mixed in October with slower retail sales (albeit 10% yoy ain't bad), steady industrial production at 6.1% yoy and a pick-up in fixed asset investment helped by property investment. Having just returned from China, the one thing that struck me is that it’s as busy as ever. If you are waiting for the hard landing long predicted by the China bears it’s a bit like "waiting for Godot". 

Australian economic events and implications

In Australia, the minutes from the RBA's last Board meeting offered nothing new and a relatively upbeat speech by Governor Lowe indicated that the Bank is happily on hold for now, but labour market softness highlights that’s it still too early to rule out another interest rate cut next year. Employment rose in October, driven by a gain in full time jobs but left in place a very weak trend for full time jobs consistent with continuing very high underemployment. This in the September quarter resulted in a new record low for wages growth of just 1.9% yoy. The risk is that this in turn will result in lower inflation than the RBA is allowing for, and combined with a slowing in the housing sector, upwards pressure on bank mortgage rates from rising funding costs and a still too high $A will drive another rate cut. Bottom line: while global bond yields are on the rise on prospects for stronger US growth and a tighter Fed and this will likely see the Australian interest rate cycle turn up in 2018, we are still allowing for another RBA rate cut in the first half of next year. 

What to watch over the next week?

In the US, the manufacturing conditions PMI (Wednesday) is likely to have remained around solid levels. Expect flat existing home sales (Tuesday) and new home sales (Wednesday) after solid gains in September, continued modest growth in home prices and a bounce in durable goods orders (both Wednesday) but with little change in underlying orders. The Minutes from the last Fed meeting (also Wednesday) will be very dated.

In Europe, manufacturing and services conditions PMIs (Wednesday) are expected to have remained solid at around 53.5, consistent with a slight pick-up in economic growth.

Japan's manufacturing conditions PMI (Thursday) will be watched for further signs of improvement. Inflation data (Friday) is expected to show continuing headline deflation.

In Australia, a speech by the RBA’s Kent (Tuesday) will be watched for clues on the interest rate outlook. September quarter construction data (Wednesday) is likely to show an ongoing decline in mining engineering investment.

Outlook for markets

While the US election is out of the way, event risks could still cause short term volatility in share markets with policy uncertainty remaining high in the US (watch the senior appointments to Trump’s team), Eurozone break up risks coming back into focus with the Italian Senate referendum and Austrian presidential election re-run (both on December 4) and ECB and Fed meetings in December. Bond yields could also see more upside in the short term. However, despite continuing volatility, we anticipate shares to be higher by year end and to trend higher over the next 6-12 months helped by okay valuations, continuing easy global monetary conditions, a shift towards fiscal stimulus in the US, moderate economic growth and the shift from falling to rising profits for both the US and Australian share markets. 

Sovereign bonds are now very oversold and due for a bounce in price (or pullback in yield). But still low bond yields point to a poor medium term return potential from them. The abatement of deflationary pressures as commodity prices head up, the gradual using up of spare capacity and a shift in policy focus from monetary to fiscal stimulus indicates that the long term decline in yields since the early 1980s is probably over. Expect the trend in bond yields to be up.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors though as these two asset classes never fully adjusted to the full decline in bond yields. 

Dwelling price gains are expected to slow, as the heat comes out of Sydney and Melbourne thanks to poor affordability, tougher lending standards and as apartment supply ramps up which is expected to drive 15-20% price falls for units in oversupplied areas around 2018.

Cash and bank deposits offer poor returns. 

A shift in the interest rate differential in favour of the US as the Fed remains on its path to hike rates should see the long term trend in the $A remain down.

Eurozone shares fell 0.7% and the US S&P 500 lost 0.2% in quiet trade on Friday. Despite the soft global lead ASX 200 futures rose 0.1% so I expect a 5 to 10 point gain at the open for the Australian share market on Monday. Perhaps of more interest is the $A which fell to $0.7325 on Friday night its lowest since June after hitting a six month high just before Donald Trump’s election victory. Expectations for a narrowing in the interest differential in favour of Australia as Fed tightening swings into view are clearly weighing on the $A, which is good news for Australian companies that have to compete internationally.

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3 things you need to know about Donald Trump's victory

Monday, November 14, 2016

By Shane Oliver

The past week has all been about the US presidential election with share markets first falling and bonds and gold rallying on news of Donald Trump’s likely victory as investors initially worried about a global trade war and policy uncertainty, only to see a sharp reversal (and then some) as investors focussed on the stimulatory aspects of his policy platform. The key turning point appears to have been Donald Trump’s conciliatory victory speech which appeared to drive a focus on the more positive aspects of his policy platform (including tax cuts, deregulation and infrastructure spending) which could boost growth, inflation and interest rates in the US. Reflecting this, major share markets saw strong gains for the week overall, but with emerging market shares falling, bond yields rose sharply on expectations for higher inflation and interest rates and the $US rose, and this, along with sharp falls in Asian currencies weighed on the $A despite sharp gains in prices for metals and iron ore. For the week, US shares rose 3.8%, Eurozone shares rose 2%, Japanese shares rose 2.8%, Chinese shares rose 1.9% and Australian shares rose 3.7%.

Sectors to benefit from a Trump Presidency

US share market sectors that will benefit from deregulation and infrastructure spending under Trump – like industrials, financials, healthcare, energy and materials – rose the most, but bond yield sensitive REITs and utilities struggled. This pattern was also reflected in the Australian share market, but with resources stocks doing particularly well.

While US financials stand to benefit from plans to dismantle the US Dodd-Frank financial sector law that cracked down on banks post the GFC, global and Australian banks have rallied too on the basis that what happens in the US often goes global and that the shift back to financial sector deregulation in the US will take the wind out of the sails for further global regulatory moves under the Basle framework.    

Three key points on Donald Trump's election

Three key points on Donald Trump’s election as President of the United States.

  1. First, Trump’s victory adds impetus to the backlash against economic rationalist policies, and specifically, globalisation, that got kicked off by the Brexit vote. On the face of it, this is a threat to global growth and investment returns if it ushers in a period of lower productivity. However, with Trump, there is a twist. While his trade policies could be bad for productivity and global growth, his proposed tax cuts, infrastructure spending and industry deregulation will likely boost productivity and growth. So it could all turn out to be positive.  
  2. Second, what ultimately matters is whether we get Trump the pragmatist focussing on the fiscal stimulus (tax cuts and infrastructure spending) and industry deregulation aspects of his program, or Trump the populist, focussing particularly on aggressive protectionism. The populist is what we saw in the election campaign, but economic and political realities usually force politicians to become more pragmatic once in office. Trump’s conciliatory victory speech provided a bit of confidence that he will be more pragmatic as does his business background.  
  3. Finally, Trump’s victory adds impetus to the “great policy rotation” from relying solely on monetary policy to boost growth, to a greater reliance on fiscal stimulus (tax cuts and infrastructure spending) and structural reform (deregulation). While House Republicans are likely to want to limit any budget deficit blow out, expect agreement between Trump and Congress to be reached pretty quickly. This will likely all mean stronger growth, higher inflation, more upwards pressure on bond yields and more upwards pressure on the Fed. In the absence of much negative fallout in investment markets from Trump’s victory, the Fed remains on track to hike in December (with the US money market pricing in an 84% probability), but assuming the $US does not push too high, we could see three to four rate hikes next year rather than the one hike that the money market has priced in.

In summary, this is neutral to positive for shares (with stronger economic and profit growth offsetting the negative impact from faster Fed tightening), mostly positive for commodities (with US infrastructure spending adding to China’s), negative for bonds and positive for the $US. Emerging market shares could be relative losers though on trade fears, and the risk of a dollar funding crisis if the $US continues to rise and yield sensitive share market sectors, like REITs and utilities, are likely to be under pressure for longer as bond yields rise with cyclical sectors outperforming.

What does it mean for Australia?

For Australia, the impact of Trump’s victory also comes down to whether we get Trump the populist, as US tariffs on Chinese imports will likely invite retaliation and see Australia caught in the cross fire with a fall in demand for our exports – or Trump the pragmatist – as stronger US growth and the avoidance of a debilitating trade war will ultimately be good for Australia.

I have a leaning towards the latter. In the meantime, with little negative fallout in investment markets from Trump’s victory, there are little in the way of implications for the RBA regarding Australian interest rates in the short term. Looking out further, if Trump’s policies help drive stronger US growth and inflation, then the beneficial impact on Australia could help eventually help drive higher interest rates here – but that’s a 2018 story at the earliest.

Major global economic events and implications

US data remained good, with a rise in small business optimism, job openings and hiring remaining strong, jobless claims remaining low and a reported easing in bank lending standards to households. Meanwhile, the mortgage delinquency rate for US households has fallen to its lowest since 2006. 

Japanese wages growth remained very weak in September and machine orders fell, but bank lending and the Eco Watcher’s economic confidence index rose more than expected and corporate bankruptcies are down 8% year-on-year (yoy).

Chinese import and export data for October remained weak but consumer price inflation rose slightly to 2.1% yoy (from 1.9%) and producer price inflation rose to 1.2% yoy which is up from -5.9% a year ago. The upswing in producer prices is driven by stronger commodity prices and a stabilisation in Chinese economic growth and is positive for nominal economic growth and profits in China.

Australian economic events and implications

In Australia, housing finance unexpectedly rose in September, led by strength in lending to investors, and ANZ job ads rose by 1% but business and consumer confidence fell slightly leaving them slightly above or around their long term averages. Nothing to get too excited about here, but the reinvigoration of lending to property investors at a time when Sydney and Melbourne price growth and auction clearance rates remains robust is a bit of a concern. 

What to watch over the next week?

In the US, the consumer will be back in focus with October retail sales data (Tuesday) expected to show solid growth, although election uncertainty may have acted as a bit of a drag. Meanwhile, expect modest growth in industrial production (Wednesday), continued strength in home builder conditions (also Wednesday) and a rebound in housing starts (Thursday) and core inflation remaining around 2.2% yoy.

In Japan, September quarter GDP growth (Monday) is expected to come in around 0.2% quarter on quarter (qoq) (unchanged from the June quarter).

Chinese activity data for October (Monday) is likely to show a slight rise in industrial production to 6.2% yoy (from 6.1%), but retail sales growth is expected to remain unchanged at 10.7% yoy and investment at 8.2% yoy.

In Australia, wages (Wednesday) are expected to rise 0.6% qoq, leaving annual growth at a record low of 2.1% yoy. Meanwhile, October jobs data (Thursday) is expected to show a 30,000 bounce in employment with unemployment rising to 5.7% (from 5.6%) as participation bounces back after recent falls. The Minutes from the last RBA Board meeting and a speech by Governor Lowe are likely to confirm that the RBA has a neutral bias on interest rates for now.

Outlook for markets

While the US election is out of the way, event risks could still cause short term volatility in share markets, with policy uncertainty remaining high in the US (watch the senior appointments to Trump’s team in the weeks ahead), Eurozone break up risks likely coming back into focus with the Italian Senate referendum and Austrian presidential election re-run (both on December 4) and ECB and Fed meetings in December.

Bond yields could also see more upside in the short term. However, despite continuing volatility, we anticipate shares to be higher by year end and to trend higher over the next 6-12 months helped by okay valuations, continuing easy global monetary conditions, a shift towards fiscal stimulus in the US, moderate economic growth and the shift from falling to rising profits for both the US and Australian share markets. 

Sovereign bonds are now very oversold and due for a bounce in price (or pullback in yield). But still, low bond yields point to a poor medium-term return potential from them. While it’s hard to get too bearish on bonds in a world of fragile growth, spare capacity, low inflation and ongoing shocks, the abatement of deflationary pressures as commodity prices head up, the gradual using up of spare capacity and a shift in policy focus from monetary to fiscal stimulus indicates that the cyclical decline in bond yields (and likely too the long term decline since the early 1980s) is probably over. Expect the trend in bond yields to be up.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors though, as these two asset classes never fully adjusted to the full decline in bond yields. 

Dwelling price gains are expected to slow, as the heat comes out of Sydney and Melbourne thanks to poor affordability, tougher lending standards and as apartment supply ramps up which is expected to drive 15-20% price falls for units in oversupplied areas around 2018.

Cash and bank deposits offer poor returns. 

A shift in the interest rate differential in favour of the US as the Fed remains on its path to hike rates should see the long term trend in the $A remain down. 

Eurozone shares fell 0.5% and the US S&P 500 fell 0.1% on Friday as investors paused to digest Donald Trump’s election victory and the oil price fell. The soft global lead saw ASX 200 futures fall 0.3% so I expect the Australian market to open down 15 points or so on Monday morning. With the ASX 200 rising 3.7% over the last week some short term pull back is to be expected.

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3 things you need to know about Donald Trump's victory

Monday, November 14, 2016

By Shane Oliver

The past week has all been about the US presidential election with share markets first falling and bonds and gold rallying on news of Donald Trump’s likely victory as investors initially worried about a global trade war and policy uncertainty, only to see a sharp reversal (and then some) as investors focussed on the stimulatory aspects of his policy platform. The key turning point appears to have been Donald Trump’s conciliatory victory speech which appeared to drive a focus on the more positive aspects of his policy platform (including tax cuts, deregulation and infrastructure spending) which could boost growth, inflation and interest rates in the US. Reflecting this, major share markets saw strong gains for the week overall, but with emerging market shares falling, bond yields rose sharply on expectations for higher inflation and interest rates and the $US rose, and this, along with sharp falls in Asian currencies weighed on the $A despite sharp gains in prices for metals and iron ore. For the week, US shares rose 3.8%, Eurozone shares rose 2%, Japanese shares rose 2.8%, Chinese shares rose 1.9% and Australian shares rose 3.7%.

Sectors to benefit from a Trump Presidency

US share market sectors that will benefit from deregulation and infrastructure spending under Trump – like industrials, financials, healthcare, energy and materials – rose the most, but bond yield sensitive REITs and utilities struggled. This pattern was also reflected in the Australian share market, but with resources stocks doing particularly well.

While US financials stand to benefit from plans to dismantle the US Dodd-Frank financial sector law that cracked down on banks post the GFC, global and Australian banks have rallied too on the basis that what happens in the US often goes global and that the shift back to financial sector deregulation in the US will take the wind out of the sails for further global regulatory moves under the Basle framework.    

Three key points on Donald Trump's election

Here are three key points on Donald Trump’s election as President of the United States.

  1. First, Trump’s victory adds impetus to the backlash against economic rationalist policies, and specifically, globalisation, that got kicked off by the Brexit vote. On the face of it, this is a threat to global growth and investment returns if it ushers in a period of lower productivity. However, with Trump, there is a twist. While his trade policies could be bad for productivity and global growth, his proposed tax cuts, infrastructure spending and industry deregulation will likely boost productivity and growth. So it could all turn out to be positive.  
  2. Second, what ultimately matters is whether we get Trump the pragmatist focussing on the fiscal stimulus (tax cuts and infrastructure spending) and industry deregulation aspects of his program, or Trump the populist, focussing particularly on aggressive protectionism. The populist is what we saw in the election campaign, but economic and political realities usually force politicians to become more pragmatic once in office. Trump’s conciliatory victory speech provided a bit of confidence that he will be more pragmatic as does his business background.  
  3. Finally, Trump’s victory adds impetus to the “great policy rotation” from relying solely on monetary policy to boost growth, to a greater reliance on fiscal stimulus (tax cuts and infrastructure spending) and structural reform (deregulation). While House Republicans are likely to want to limit any budget deficit blow out, expect agreement between Trump and Congress to be reached pretty quickly. This will likely all mean stronger growth, higher inflation, more upwards pressure on bond yields and more upwards pressure on the Fed. In the absence of much negative fallout in investment markets from Trump’s victory, the Fed remains on track to hike in December (with the US money market pricing in an 84% probability), but assuming the $US does not push too high, we could see three to four rate hikes next year rather than the one hike that the money market has priced in.

In summary, this is neutral to positive for shares (with stronger economic and profit growth offsetting the negative impact from faster Fed tightening), mostly positive for commodities (with US infrastructure spending adding to China’s), negative for bonds and positive for the $US. Emerging market shares could be relative losers though on trade fears, and the risk of a dollar funding crisis if the $US continues to rise and yield sensitive share market sectors, like REITs and utilities, are likely to be under pressure for longer as bond yields rise with cyclical sectors outperforming.

What does it mean for Australia?

For Australia, the impact of Trump’s victory also comes down to whether we get Trump the populist, as US tariffs on Chinese imports will likely invite retaliation and see Australia caught in the cross fire with a fall in demand for our exports – or Trump the pragmatist – as stronger US growth and the avoidance of a debilitating trade war will ultimately be good for Australia.

I have a leaning towards the latter. In the meantime, with little negative fallout in investment markets from Trump’s victory, there are little in the way of implications for the RBA regarding Australian interest rates in the short term. Looking out further, if Trump’s policies help drive stronger US growth and inflation, then the beneficial impact on Australia could help eventually help drive higher interest rates here – but that’s a 2018 story at the earliest.

Major global economic events and implications

US data remained good, with a rise in small business optimism, job openings and hiring remaining strong, jobless claims remaining low and a reported easing in bank lending standards to households. Meanwhile, the mortgage delinquency rate for US households has fallen to its lowest since 2006. 

Japanese wages growth remained very weak in September and machine orders fell, but bank lending and the Eco Watcher’s economic confidence index rose more than expected and corporate bankruptcies are down 8% year-on-year (yoy).

Chinese import and export data for October remained weak but consumer price inflation rose slightly to 2.1% yoy (from 1.9%) and producer price inflation rose to 1.2% yoy which is up from -5.9% a year ago. The upswing in producer prices is driven by stronger commodity prices and a stabilisation in Chinese economic growth and is positive for nominal economic growth and profits in China.

Australian economic events and implications

In Australia, housing finance unexpectedly rose in September, led by strength in lending to investors, and ANZ job ads rose by 1% but business and consumer confidence fell slightly leaving them slightly above or around their long term averages. Nothing to get too excited about here, but the reinvigoration of lending to property investors at a time when Sydney and Melbourne price growth and auction clearance rates remains robust is a bit of a concern. 

What to watch over the next week?

In the US, the consumer will be back in focus with October retail sales data (Tuesday) expected to show solid growth, although election uncertainty may have acted as a bit of a drag. Meanwhile, expect modest growth in industrial production (Wednesday), continued strength in home builder conditions (also Wednesday) and a rebound in housing starts (Thursday) and core inflation remaining around 2.2% yoy.

In Japan, September quarter GDP growth (Monday) is expected to come in around 0.2% quarter on quarter (qoq) (unchanged from the June quarter).

Chinese activity data for October (Monday) is likely to show a slight rise in industrial production to 6.2% yoy (from 6.1%), but retail sales growth is expected to remain unchanged at 10.7% yoy and investment at 8.2% yoy.

In Australia, wages (Wednesday) are expected to rise 0.6% qoq, leaving annual growth at a record low of 2.1% yoy. Meanwhile, October jobs data (Thursday) is expected to show a 30,000 bounce in employment with unemployment rising to 5.7% (from 5.6%) as participation bounces back after recent falls. The Minutes from the last RBA Board meeting and a speech by Governor Lowe are likely to confirm that the RBA has a neutral bias on interest rates for now.

Outlook for markets

While the US election is out of the way, event risks could still cause short term volatility in share markets, with policy uncertainty remaining high in the US (watch the senior appointments to Trump’s team in the weeks ahead), Eurozone break up risks likely coming back into focus with the Italian Senate referendum and Austrian presidential election re-run (both on December 4) and ECB and Fed meetings in December.

Bond yields could also see more upside in the short term. However, despite continuing volatility, we anticipate shares to be higher by year end and to trend higher over the next 6-12 months helped by okay valuations, continuing easy global monetary conditions, a shift towards fiscal stimulus in the US, moderate economic growth and the shift from falling to rising profits for both the US and Australian share markets. 

Sovereign bonds are now very oversold and due for a bounce in price (or pullback in yield). But still, low bond yields point to a poor medium-term return potential from them. While it’s hard to get too bearish on bonds in a world of fragile growth, spare capacity, low inflation and ongoing shocks, the abatement of deflationary pressures as commodity prices head up, the gradual using up of spare capacity and a shift in policy focus from monetary to fiscal stimulus indicates that the cyclical decline in bond yields (and likely too the long term decline since the early 1980s) is probably over. Expect the trend in bond yields to be up.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors though, as these two asset classes never fully adjusted to the full decline in bond yields. 

Dwelling price gains are expected to slow, as the heat comes out of Sydney and Melbourne thanks to poor affordability, tougher lending standards and as apartment supply ramps up which is expected to drive 15-20% price falls for units in oversupplied areas around 2018.

Cash and bank deposits offer poor returns. 

A shift in the interest rate differential in favour of the US as the Fed remains on its path to hike rates should see the long term trend in the $A remain down. 

Eurozone shares fell 0.5% and the US S&P 500 fell 0.1% on Friday as investors paused to digest Donald Trump’s election victory and the oil price fell. The soft global lead saw ASX 200 futures fall 0.3% so I expect the Australian market to open down 15 points or so on Monday morning. With the ASX 200 rising 3.7% over the last week some short term pull back is to be expected.

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How the US election result could impact the markets

Monday, November 07, 2016

US election uncertainty really hit financial markets over the past week as news of the FBI’s intervention saw average opinion poll support for Clinton over Trump decline to 1 to 2 points. This along with falling oil prices saw most share markets fall. While Chinese shares rose 0.4%, US shares fell 1.9%, Eurozone shares fell 4%, Japanese shares fell 3.1% and Australian shares fell 2%. Bond yields in major countries declined and gold rose on safe haven demand. While prices for metals and iron ore rose, oil fell on a strong US oil inventory build and fears OPEC won’t implement its deal to cut production. The $US fell on the back of election uncertainty and this along with higher metal prices saw the $A rise.

If the US election result is to be reasonably decisive – a big if! – we should have an idea who won by around 1-2pm (Sydney time) on Wednesday. What can we expect from investment markets? I tend to think the median American voter will reject misogynism, racism and narcissism and this combined with the Democrats natural advantage in the Electoral College favours a Clinton win, but following the narrowing in the polls over the past week it is now a very close call. Even if Clinton wins there is close to zero chance of the Democrats retaking control of Congress in a clean sweep. The last few weeks have seen shares sell off when developments favoured Trump and rally when developments favoured Clinton and get the jitters when there is talk of a Democrat clean sweep – suggesting investors favour a Clinton victory as long as it’s not a clean sweep. With US shares down 5% and Australian shares down 7% from August highs it seems investors have factored in maybe a 50/50 bet on the election outcome. Given all this:

  • A Trump victory would likely trigger a further initial bout of “risk off” with shares down by 5% or so (both in the US and globally) and safe havens like bonds and gold rallying as investors fret particularly about his protectionist trade policies triggering a global trade war. Australian shares would be particularly vulnerable to this given our high trade exposure (exports are 21% of GDP in Australia against 13% in the US). While the Fed would be less likely to hike in December if Trump wins the $A would likely still suffer from the threat to trade and the initial “risk-off” environment. A Trump victory to the extent that it leads to falls in investment markets and worries about a global trade war may also increase the chance of another RBA rate cut in Australia.
  • Beyond the initial reaction, share markets could then settle down and get a boost to the extent that his stimulatory economic policies look like being supported by Congress, but much would ultimately depend on whether we get Trump the pragmatist (who backs down on his more extreme policies, eg around protectionism) or Trump the populist. Congress along with economic and political reality can probably be relied on to take some of the edge of Trump’s policies to some degree, but this would take time.
  • A Clinton/Democrat clean sweep of the Presidency and Congress would likely also trigger a further bout of nervousness in US shares as it would be easier for Clinton to implement less business friendly tax and regulatory policies that would weigh particularly on US health, energy and financial stocks. This would likely be more focussed on US shares though with less of an impact on global/Australian shares. However, this scenario is now very unlikely.
  • The best outcome for shares would be a Clinton victory but with Republicans retaining control of at least the House as this would be seen as “more of the same”. This would likely see a decent relief rally in US, global and Australian share markets – particularly given that they are already technically oversold. While there may be concerns about her policies on income and capital gains tax and regulation, these would have little chance of getting through a Republican Congress. The downside is that if her win is narrow a Clinton presidency is likely to be weak with a poor mandate, ongoing controversy around the FBI investigation of her emails, issues around the Clinton Foundation and very low popularity. Against this background Congressional Republicans are unlikely to be particularly cooperative in implementing sensible policy changes. Historically, since 1927 US total share returns have been strongest at an average 16.7% pa when there has been a Democrat president and Republican control of the House, the Senate or both.

Source: Bloomberg, AMP Capital

Of course there is the question of what will happen if the result is unclear - either with no candidate winning the necessary 270 Electoral College votes or the result being so close that it’s contested as occurred in 2000 between Bush and Gore. Either result will likely see shares under pressure short term. In the first scenario, the House of Representatives will decide with one vote to each group of state representatives and since it will almost certainly have a Republican majority Trump will win. But get this: the Senate then chooses the vice-president from top two candidates so we could have Vice-President Clinton to President Trump! In the second scenario, the 2000 experience saw US shares fall about 8% and safe havens rally until a result was declared - but prior to the 2000 election shares had rallied (whereas now they have fallen) and the falls were likely affected by the tech wreck recession around that time.

Finally, while all this sounds a bit messy – just recall the fears around Brexit, which after a few days saw global markets move on to focus on other things with shares rebounding. And at least this time around there is less complacency ahead of the event. Global and Australian shares rallied into the Brexit vote, whereas this time around they have already fallen 3-5% over the last two weeks to price in maybe a 50% chance of a Trump victory and are already technically oversold and primed for a rebound if the news is good or uncertainty is reduced.

Looking beyond the boulder in the investment road that is the US election… the news over the last week or so has actually been reasonably good. This is most evident in business conditions PMIs, which rose in most countries in October both for services and manufacturing and are trending up after a soft patch earlier this year. This is good for profits and hence share markets. While it keeps the Fed on track to raise interest rates in December it’s a far more positive back drop (US election uncertainty aside) than was the case a year ago.

Source: Bloomberg, AMP Capital

Major global economic events and implications

US data was good. Personal spending saw solid growth in September, the ISM manufacturing conditions index rose adding to evidence that the manufacturing sector is healthier and the non-manufacturing conditions ISM remained strong, the trade deficit narrowed and October saw payroll employment growth of 161,000 new jobs, a fall in unemployment and a further pick up in wages growth. While faster wages growth (albeit from a low base) is bad for profit margins it’s actually good for profits as it boosts household income, consumer spending and hence corporate revenue. Meanwhile there were no surprises from the Fed which left interest rates on hold as expected but expressed more confidence on the economy and inflation and indicated that the case for a hike has continued to strengthen. The solid October jobs report provides another green light for the Fed. Bottom line: barring a shock (eg. a Trump win or bad data) the Fed remains on track to hike in December.

Revenue growth and better margins have driven an end to the profit recession in the US. The US profit reporting season is now over 80% done with 75% of companies beating on earnings and 55% beating on sales. Profits are on track to be up in the quarter, up on a year ago and up relative to the last high in 2014.

Eurozone growth continued in the September quarter at a moderate pace of 1.6% yoy with a rising trend in business conditions PMIs and confidence readings pointing to a possible pick up ahead. However, with core inflation remaining low at 0.8%, headline inflation just 0.5% and unemployment remaining high at 10% pressure on the ECB to extend it quantitative easing program beyond March next year remains.

The UK High Court’s requirement that the British parliament approve the triggering of Brexit is unlikely to stop it but reduces the chance of a hard Brexit. Meanwhile the Bank of England is now on hold. Both are short term positive for sterling.

There was no surprise from the Bank of Japan which left monetary policy unchanged. It’s already doing open ended quantitative easing anyway until inflation exceeds its 2% target.

Chinese manufacturing and services PMIs rose in October and are actually trending up adding to confidence that Chinese growth has stabilised.

Australian economic events and implications

In Australia, as expected the RBA left interest rates on hold with inflation in line with expectations and its inflation and growth expectations little changed from three months ago as confirmed in its Statement on Monetary Policy. Short of a shock – eg financial turmoil in response to a Trump victory or a run of very soft economic data - it’s hard to see the RBA cutting interest rates at its December meeting. However, with housing construction likely to slow next year, an expected slowing in house price momentum leading to fading wealth effects, falling full time jobs a concern for consumer spending, credit growth slowing, inflation risks skewed to the downside and the likely need to offset regulatory driven pressure on banks to raise mortgage rates, we are allowing for another interest rate cut in the first half of next year.

Australian economic data was a mixed bag. On the strong side the trade deficit fell sharply driven by the surge in coal prices, non-residential building approvals are rising solidly, business conditions PMIs rose in October and September retail sales saw a decent gain. But against this, retail sales volumes were soft in the September quarter, home building approvals fell sharply and credit growth is slowing. Momentum in Sydney and Melbourne home prices remains strong according to CoreLogic but its weak to moderate elsewhere and the Melbourne Institutes’ Inflation Gauge showed weak inflation continuing into the current quarter. Bottom line: the risks remain skewed to rate cuts.

What to watch over the next week?

Globally, all eyes will be on the US election, but apart form that it will be a relatively quiet week with Chinese trade and inflation data and Australian confidence data being the main areas of interest.

In the US, small business confidence (Tuesday) and consumer sentiment (Friday) may show an election related dip but data for job openings (Tuesday) is likely to remain solid.

Chinese trade data for October (Tuesday) is expected to show some improvement in exports and imports and consumer price inflation (Wednesday) is likely to edge up to 2.1% year on year and producer price inflation is expected to rise further to 0.9% yoy as higher commodity prices feed through.

In Australia, business conditions and confidence as measured by the NAB survey (Tuesday) are expected to hold at above average levels, but consumer confidence (Wednesday) may dip slightly. Housing finance (Thursday) is expected to continue to slow falling another 3% or so. Speeches by RBA officials Ryan and Debelle will be watched for any clues on interest rates.

Outlook for markets

We remain cautious on shares in the short term as event risk is high given the US election, the Italian Senate referendum & Austrian presidential election re-run (both on December 4) and ECB and Fed meetings in December. Bond yields could also see more upside in the short term. However, after any further short term weakness, we anticipate shares to trend higher over the next 6-12 months helped by okay valuations, continuing easy global monetary conditions, moderate economic growth and the shift from falling to rising profits for both the US and Australian share markets.

Still ultra-low bond yields point to a poor medium term return potential from them, but it’s hard to get too bearish on bonds in a world of fragile growth, spare capacity, low inflation and ongoing shocks.

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

Dwelling price gains are expected to slow, as the heat comes out of Sydney and Melbourne thanks to poor affordability, tougher lending standards and as apartment supply ramps up which is expected to drive 15-20% price falls for units in oversupplied areas around 2018.

Cash and bank deposits offer poor returns.

The outlook for the $A has become murky. A shift in the interest rate differential in favour of the US as the Fed remains on its path to hike rates should see the long term trend remain down and the $A normally overshoots on the downside after the bursting of commodity price booms and this remains our base case. But against this, the stabilisation and rising trend in some commodity prices and the continued gradual nature of Fed rate hikes suggest ongoing upside risks in the short term. The danger is that the latter will threaten the rebalancing of the economy and the best defence against this is for the RBA to revert to a clear easing bias even if it never acts on it.

Eurozone shares fell 0.7% on Friday and the US S&P 500 fell 0.2% as US election uncertainty continued to weigh along with a further fall in oil prices. Reflecting the weak global lead ASX 200 futures fell 0.6% so I expect another weak open for the Australian share market on Monday driven by US election fears with the ASX 200 likely to fall 25 to 30 points.

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Why has the Australian market slipped?

Monday, October 31, 2016

By Shane Oliver

Investment markets and key developments over the past week

Shares were mixed over the last week, with Japanese shares up 1.5% and Chinese shares up 0.4%, but Eurozone shares flat, US shares down 0.7% and Australian shares down 2.7%. US shares were hit late on Friday by renewed election uncertainty, as the FBI announced it was reopening its investigation into Hillary Clinton’s use of a private email server while Secretary of State. Bond yields continued to back up as prospects for a December Fed rate hike continue to firm and as stronger UK growth diminished prospects for a further Bank of England easing. Commodity prices were mixed with oil down but metals up and the $A fell slightly despite a fall in the $US. 

Why the recent poor performance from Australian shares?

While global shares have been range bound over the last few months (with Eurozone and Japanese shares benefitting from falls in their currencies and the US share market down a bit) Australian shares are down 5% from their August high. This relative underperformance reflects a combination of:

  • concerns about the Fed and the US election that seem to be weighing on most share markets at present; 
  • a reversal of the huge bond rally that had helped the higher dividend paying Australian share market and sectors like real estate investment trusts up to mid-year; 
  • a soft patch in consumer spending weighing on retailers; 
  • and stock specific issues. 

Of these, the turn up in bond yields is perhaps most significant, taking a huge toll on defensive high-yield sectors like REITs. With the Fed on track to hike again in December and the RBA likely to be on hold for now, a further back up in bond yields is likely into December. However, while the bond bull market is likely over as global inflation bottoms, the back up in yields generally is likely to be gradual as global growth is set to remain constrained, the Fed is likely to remain gradual in raising interest rates and other major central banks including the RBA are likely on hold or skewed to easing further. Meanwhile, defensive yield sectors are getting very oversold and due for a bounce and cyclical sectors have more upside if as we expect that global and Australian economies continue to see moderate growth. Bottom line – it’s just another correction.  

Spain is moving out of limbo with the focus shifting to Italy. The political impasse that has hung over Spain following inconclusive elections in December and June looks likely to be resolved with the Socialist party voting to abstain from voting in a parliamentary confidence vote that will then see Mariano Rajoy confirmed as PM. However, political risk in Europe has shifted to Italy and Austria. Italy will see a referendum on reducing the power of its Senate on December 4 with PM Matteo Renzi seeking to reduce its power in order to proceed with economic reform (something maybe Australia should think about!) and threatening to resign if the referendum is not passed, which would then provide a boost to the mostly anti-Euro Five Star Movement. On the same day, Austria will see a re-run of its presidential election with the far right candidate being anti-Euro. So, if these go the wrong way, we could see another bout of Eurozone break up fears. Either way I remain of the view that the Eurozone will continue to hang together – mainland Europeans are far more attached to the EU and Eurozone than the UK ever was, much of the recent rise in populists in Europe is really a backlash against austerity than necessarily the Euro (which remains popular). What’s more, European shares remain very undervalued.

Based on history, the best outcome for US shares will be a Clinton victory, but with the Republicans retaining control of at least the House of Representatives. Since 1927, US total share returns have been strongest at an average 16.7% pa when there has been a Democrat president and Republican control of the House, the Senate or both. By contrast, the return has only averaged 8.9% pa when the Republicans controlled the presidency and Congress. 

Source: Bloomberg, AMP Capital

A Trump victory would likely trigger an initial bout of “risk off” with shares down (both in the US and globally), bonds rallying and the $US up as investors fret about his economic policies, particularly his protectionist trade policies triggering a global trade war. Australian shares and the $A would be particularly vulnerable to this, given our high trade exposure. But a Clinton/Democrat clean sweep of the Presidency and Congress would likely also trigger a bout of nervousness in US shares as it would be easier for Clinton to implement less business friendly tax and regulatory policies that would weigh on US health, energy and financial stocks. This would likely be more focussed on US shares though with less of an impact on global/Australian shares. The best outcome for shares would be a Clinton victory, but with Republicans retaining control of at least the House, as this would be seen as more of the same. While Clinton was ahead in the latest polls by an average 5.2 points, these were taken before the FBI reopened an investigation into her use of a private email server while Secretary of State, which adds to uncertainty going into the final week of the election campaign. In any case, there is no sign of a wave of support going towards the Democrats that will see them win the necessary 30 seats to take the House.

Major global economic events and implications

US data was mostly good. Manufacturing and services conditions PMIs are up solidly, home sales are strong and home prices continue to rise and unemployment claims remain low. September quarter GDP growth accelerated to 2.9% annualised, as the inventory cycle turned and trade contributed strongly to growth offsetting softer growth in consumer spending. Durable goods orders are trending sideways though and consumer confidence fell but this looks to be related to election uncertainty. This is all consistent with a December rate hike assuming a Clinton victory in the upcoming election. But continued soft wages growth (with the Employment Cost Index up only 2.3% year-on-year in the September quarter) and constrained economic growth will keep likely the Fed gradual through 2017.

Despite a few high profile misses, the US September quarter profit reporting season is actually looking pretty good … the profit recession looks to have ended. Of the 299 S&P 500 companies to report so far, 78% have beat on earnings and 59% have beat on sales. Profits are now expected to be up 4% on the June quarter and up 15% from their March quarter low and to surpass their 2014 high. A 4% year-on-year gain in revenue is a key driver. 

Eurozone business conditions PMIs also rose strongly in October as did economic confidence pointing to continued moderate growth.

Japanese data was also solid with stronger manufacturing conditions, a rise in small business confidence, an improvement in household spending and solid labour market indicators. Deflation continued in September though with core inflation falling to zero.

Chinese industrial profits slowed in September to 7.7% year-on-year, but consumer confidence spiked higher in October.

Australian economic events and implications

Inflation remains very low, but maybe not low enough to trigger another RBA rate cut just yet. While September quarter CPI inflation at 0.7% quarter-on-quarter was a bit higher than expected, this was mainly due to prices for fruit and vegetables, electricity, tobacco and property rates while underlying inflation at 0.3% quarter-on-quarter was a bit lower than expected, with ongoing evidence that deflationary pressures are still working through the economy. However, on balance it is probably not enough to trigger an immediate rate cut as inflation is in line with the RBA’s own expectations, economic growth looks to be reasonable and rising commodity prices are set to boost national income. The latter was reflected in the second rise in the goods terms of trade in row in the September quarter with a further rise likely in the December quarter as higher coal and iron ore prices feed through. Meanwhile new home sales rose again in September and remain strong and producer price inflation remains very low.

What to watch over the next week?

In the US, the Fed (Wednesday) is very unlikely to raise interest rates, particularly with a “risky” election just six days later but the post meeting statement is likely to confirm that the Fed is on track to raise rates in mid-December (the market probability is just 17% for a November hike and 69% for a December hike). Meanwhile, September quarter earnings reports will continue to flow with around 100 S&P 500 companies due to report, the October ISM manufacturing conditions index (Tuesday) is likely to show a further improvement and jobs data (Friday) is expected to show continued solid jobs growth of around 170,000, a slight fall in the unemployment rate to 4.9% but continued modest wages growth. Meanwhile, core inflation according to the private consumption deflator (Monday) is likely to have remained unchanged at 1.7% year-on-year in September.

In the Eurozone, September quarter GDP data (Monday) is expected to show continued moderate GDP growth and expect a further rise in October CPI inflation (Monday) as the fall in oil prices from a year ago drops out but core inflation to remain around 0.8% year-on-year.  

Japanese industrial production for September (Monday) is expected to show continued growth and the Bank of Japan (Tuesday) is unlikely to make any changes to monetary policy after the further easing announced a month or so ago.

Chinese manufacturing conditions PMIs for October (Tuesday) are likely to pause or slow slightly but remain consistent with a stabilisation in growth.

In Australia, it’s a close call but the RBA is expected to leave interest rates on hold at its monthly Board meeting (Tuesday). September quarter inflation was low on an underlying basis but probably not low enough to trigger another cut just yet, as it is in line with the RBA’s own expectations, economic growth in Australia looks reasonable with the worst of the mining investment slump behind us and a rise in commodity prices is starting to boost national income again. As such, the RBA can afford to be patient in waiting for inflation to head back to target and thereby avoid the risk of adding to financial instability (read a further acceleration in Sydney and Melbourne home price gains) with another rate cut for now. Overall, we think that the RBA will leave rates on hold at its Melbourne Cup Day meeting, but that with inflation remaining very low, the $A still uncomfortably high and jobs data softening lately, it's premature to close the door on another rate cut but that’s more likely to be a 2017 story. The Reserve Bank’s Statement on Monetary Policy (Friday) will likely see little change to the RBA’s growth and inflation forecasts.

On the data front, expect credit growth (Monday) to remain moderate, CoreLogic home price growth (Tuesday) to remain solid, building approvals (Wednesday) to fall 6%, the trade deficit (Thursday) to show a further decline as higher coal prices flow through and retail sales (Friday) to grow 0.2% in September but just 0.1% in the September quarter in real terms.

Outlook for markets

We remain cautious on shares in the short term as event risk is high for the months ahead including ongoing debate around the Fed and ECB, the US election on November 8 and the Italian Senate referendum and Austrian presidential election re-run (both on December 4). Bond yields could also see more upside in the short term. However, after any short term weakness, we anticipate shares to trend higher over the next 6-12 months helped by okay valuations, continuing easy global monetary conditions, moderate economic growth and the shift from falling to rising profits for both the US and Australian share markets. 

Still ultra-low bond yields point to a poor medium-term return potential from them, but it’s hard to get too bearish on bonds in a world of fragile growth, spare capacity, low inflation and ongoing shocks.

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

Dwelling price gains are expected to slow, as the heat comes out of Sydney and Melbourne thanks to poor affordability, tougher lending standards and as apartment supply ramps up which is expected to drive 15-20% price falls for units in oversupplied areas around 2018.

Cash and bank deposits offer poor returns. 

The outlook for the $A has become murky. A shift in the interest rate differential in favour of the US as the Fed remains on its path to hike rates should see the long term trend remain down and the $A normally overshoots on the downside after the bursting of commodity price booms and this remains our base case. But against this, the stabilisation and rising trend in some commodity prices and the continued gradual nature of Fed rate hikes suggest ongoing upside risks in the short term. The danger is that the latter will threaten the rebalancing of the economy and the best defence against this is for the RBA to revert to a clear easing bias even if it never acts on it. 

Eurozone shares fell 0.1% on Friday and the US S&P 500 lost 0.3% giving up an earlier gain of 0.4% as the FBI announced it had reopened an investigation into Hilary Clinton’s use of a private email server. The weak global lead saw ASX 200 futures fall 0.1%, so I expect Australian shares to open down around 5 points on Monday morning – although this may be affected by whether there is more news regarding the FBI investigation of Clinton’s emails and the outcome of an OPEC meeting regarding oil production in Vienna.

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3 reasons not to fear the Fed

Monday, October 24, 2016

By Shane Oliver

Global share markets rose over the past week, helped by generally good economic data, more evidence US earnings have bottomed, confidence that the Fed will be gradual in raising interest rates and dovish comments from ECB President, Mario Draghi. US shares rose 0.4%, Eurozone shares gained 1.6%, Japanese shares rose 1.9% and Chinese shares rose 0.7% but Australian shares fell 0.1%. Bond yields generally fell, helped by Draghi’s comments, the oil price rose 1.2% but metal prices fell and the $US rose further. While the Aussie dollar briefly made it above $US0.77, it fell back after the release of soft jobs data. 

Three big differences compared to last year’s Fed scare

While expectations for a December Fed rate hike are continuing to build, investment markets seem to be taking it a bit better than was the case in the run up to last December’s eventual rate hike. At its core, there are three big differences between now and last year.

1. The global and US growth outlook is more positive now.

2. US earnings now look to have bottomed, whereas a year ago they were falling.

3. And thirdly, the uncertainty around where the Renminbi will go and Chinese capital outflows is a lot less. While event risk is high at present – with the Fed, the US election, Eurozone risk and the ECB – and this could drive short term volatility or a correction in global and Australian shares – the broad trend in shares is likely to remain up.

Trump v Clinton

Hillary Clinton is maintaining her lead but the Democrats still unlikely to take the House. While Trump's performance in the final presidential debate may have been his best for the three debates, it was not a knock out and polls had Clinton as the winner (e.g. the CNN poll had Clinton at 52% and Trump at 39%).

According to the Real Clear Politics average of major polls, Clinton is ahead by 6.2 points and the Mexican Peso (perhaps the best guide to market expectations regarding the election outcome) is up 6% since the first debate. However, there's still no evidence of a huge wave of support flowing to the Democrats that will be sufficient to see them pick up the necessary 30 seats to win a majority in the House of Representatives. So my base case remains a 70% probability of a Clinton victory, but with the Republican’s retaining control of the House (with maybe a loss of 10-15 seats). This would be a “more of the same” outcome for investment markets. Meanwhile, Trump’s comments that the election is rigged (yeah right!) and that he may not accept the result unless “ … I win” coming on the back of his comments about women, Hispanics, Muslims, China, invitations to Russia to hack into America, etc, along with his short fuse and erratic nature add to the concern that he is not fit to be president. The sooner the Republicans can recover from this mess, reunite and return to being the GOP that gave the world Lincoln and Reagan, the better.

In Australia, a speech by RBA Governor Philip Lowe, along with the minutes from the RBA’s last Board meeting, add to expectations that the RBA is not in a hurry to cut rates again, with Lowe more comfortable with the growth outlook and not wanting to push inflation quickly back to target if it risked financial instability. While his comment about the importance of September quarter inflation data for the interest rate outlook and the need to guard against inflation expectations falling too far leave the door to another rate cut open, the hurdle to do so at this stage looks to be relatively high. 

Major global economic events and implications

US data was generally OK. Jobless claims remain very low and existing home sales, the leading index and industrial production all rose. However, manufacturing conditions in the New York and Philadelphia regions were mixed. While housing starts fell sharply in September, this was all due to volatile starts of multi-dwelling buildings and permits to build new homes and home builder conditions were strong, indicating that housing activity will remain solid. Meanwhile, the Fed’s Beige book continued to point to “modest to moderate” economic growth, “tight” labour market conditions but “modest” wage growth and “mild” inflation. The latter was confirmed by the September CPI, which showed rising headline inflation as the oil price plunge falls out, but a slight fall back in core inflation to 2.2% year-on-year. All of this is consistent with the Fed hiking in December (with the money market attaching a 68% probability) but remaining gradual thereafter in raising rates. 

It’s still early days in the US September quarter profit reporting season, but so far so good. Of the 116 S&P 500 companies to report so far, 81% have beat on earnings and 66% have beat on sales. Profits are on track to be to up for the second quarter in a row and are likely to be up year-on-year.

The European Central Bank (ECB) leaves monetary policy on hold, but looks on track for some sort of extension to its quantitative easing program. President Draghi’s comments were mostly dovish setting up for a likely extension (and widening of the assets it can buy) at its early December meeting. However, it may opt to move towards a more flexible approach where the amount of monthly QE is varied depending on bond yields and expectations regarding inflation. Meanwhile, the ECB’s September quarter bank lending survey showed strong demand for loans across the board which is a good sign, but while lending standards eased for households they were unchanged for corporates.

Chinese growth remains stable, with September quarter GDP growth unchanged at 6.7% year-on-year and improvements in growth for retail sales and investment. While industrial production slowed slightly, this may be due to G20 factory shutdowns and one less working day this September. Meanwhile, growth in money supply and credit was generally strong adding to confidence that growth has stabilised although the problem of high debt growth (flowing from too much saving) remains.

Australian economic events and implications

Soft Australian jobs data likely payback for unbelievably strong growth last year. Employment fell for the second month in a row in September, full time employment is now negative year-on-year, hours worked are weak and only falling participation is stopping unemployment from rising. The soft jobs data keeps alive the prospect of another RBA rate cut, but the monthly jobs survey remains of dubious quality and the recent weakness could be just payback for last year's too-good-to-be-believed jobs surge. In other words, more noise than signal and so the RBA is likely to look through it.

What to watch over the next week?

In the US, the main focus is likely to be on September quarter earnings reports, with over 100 S&P 500 companies due to report, September quarter GDP growth (Friday) which is expected to show a modest improvement in economic growth to 2.5% annualised after three quarters around 1% and September quarter employment costs (also Friday) which are expected to remain subdued around 2.3% year-on-year growth. In other data, expect the Markit manufacturing conditions PMI (Monday) to remain modest at around 51.5, home price data to show continued growth and consumer confidence to fall back a bit on election uncertainty (all Tuesday), new home sales (Wednesday) to fall slightly but pending home sales (Thursday) to bounce back and little change in durable goods orders (also Thursday). Overall, this won’t be enough to deliver a surprise rate hike in November but will leave the Fed on track to hike in December.

In the Eurozone, expect October business conditions indicators (Monday) and economic confidence indicators (Friday) to remain consistent with moderate growth. 

Japanese data for September to be released on Friday is expected to show continued labour market strength, but weak household spending, ongoing CPI deflation and a further fall in core inflation to around 0.1% year-on-year.

In Australia, the focus will be on September quarter inflation data (Wednesday) which will be the main driver of whether the RBA cuts rates again at its November meeting. Thanks to higher prices for fruit and vegetables, utility charges and rates and an increase in tobacco excise only partly offset by lower petrol prices headline inflation is expected to be up 0.6% quarter-on-quarter taking annual inflation to 1.3% (from 1%). The underlying measures of inflation (the average of the trimmed mean and weighted median) are expected to be around 0.5% quarter-on-quarter or 1.6% year-on-year. We have been allowing for another RBA rate cut in November but given recent solid economic data, evidence that the terms of trade and hence national income has bottomed and signs that the new RBA Governor would prefer not to cut rates again, underlying inflation would probably need to be 0.3% quarter-on-quarter or less to clearly bring on another rate cut in November. 

Australian data for September quarter export and import prices (Thursday) will likely provide further evidence that the terms of trade has bottomed and producer price inflation and new home sales data will be released Friday.

Outlook for markets

We remain cautious on shares in the short term as event risk is high for the months ahead including ongoing debate around the Fed and ECB, issues around Eurozone banks, the US election on November 8 and the Italian Senate referendum and Austrian presidential election re-run (both on December 4). However, after any short-term weakness, we anticipate shares to trend higher over the next 12 months helped by okay valuations, continuing easy global monetary conditions, moderate economic growth and the shift from falling to rising profits for both the US and Australian share markets. 

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

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

Dwelling price gains are expected to slow, as the heat comes out of Sydney and Melbourne thanks to poor affordability, tougher lending standards and as apartment supply ramps up which is expected to drive 15-20% price falls for units in oversupplied areas around 2018.

Cash and bank deposits offer poor returns. 

The outlook for the $A has become murky. A shift in the interest rate differential in favour of the US as the Fed remains on its path to hike rates should see the long term trend remain down and the $A normally overshoots on the downside after the bursting of commodity price booms and this remains our base case. But against this, the stabilisation and rising trend in some commodity prices and the continued gradual nature of Fed rate hikes suggest ongoing upside risks in the short term. The danger is that the latter will threaten the rebalancing of the economy and the best defence against this is for the RBA to revert to a clear easing bias even if it never acts on it.

Eurozone shares and the US S&P 500 were both flat on Friday. Reflecting this the ASX 200 futures contract fell just 1 point, so I expect a flat start to trade for the Australian share market on Monday morning.

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