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

Signs are pointing to an August rate cut

Monday, July 25, 2016

By Shane Oliver

It’s now four weeks since the Brexit panic on June 24 and since then US shares are up 7%, Eurozone shares are up 6%, British shares are up 10%, Australian shares are up 7% and Japanese shares are up 11%. Fears around Brexit’s global impact look to have been wildly exaggerated. The only really lasting impact (so far) has been on the British pound which is down another 4% leaving it down 11% from June 23rd, which reflects the negative impact of Brexit on the UK economy.

Over the past week, the rally in shares generally continued with US shares up 0.6%, Eurozone and Japanese shares up 0.8% and Australian shares up 1.3% but Chinese shares down 1.6%. A combination of good economic data, good US profit results, the absence of a major negative impact outside the UK from Brexit and talk of more policy stimulus in parts of the world are continuing to help. Bond yields were generally flat to down, commodity prices fell and the $A fell partly in sympathy with NZ moves towards another monetary easing. 

The talk around Japan’s planned fiscal stimulus is continuing to get ramped up with the size of the package supposedly going from ¥10trillion, to ¥20trillion to maybe even ¥30trillion which is around 6% of GDP, albeit it depends how many years it is spread over. If, as we expect, it’s focussed on encouraging consumers to spend more then it should have a reasonable chance of success. 

In maybe a sign of things to come in Australia – NZ looks to be heading for another rate cut. After a low inflation outcome, a further tightening in restrictions on residential mortgage lending and the Reserve Bank of New Zealand stating that “a decline in the [$NZ] is needed”, the RBNZ has set the scene for a rate cut next month. In fact, it said that “it seems likely that further policy easing will be required”.

The IMF downgraded it's global growth forecasts to 3.1% for 2016 (from 3.2%) and to 3.4% for 2017 (from 3.5%) on Brexit risks - but hardly a surprise. It must often strike the ordinary investor as weird that much fanfare is given to the IMF downgrading its growth forecasts, but share markets seem to largely ignore it. There are several reasons for this but in essence it’s because the market (and most economists) have already moved ahead of the IMF and the IMF global growth forecasts have been starting out too optimistic for years now. Since early this decade, they have been starting out forecasting 4% global growth for the year ahead, only to end around 3%. This is not great – but it’s not bad either! Just more of the same. 

One positive from the last week – we learned that Trumps can say thoughtful things. Not to worry that they were Michelle Obama’s. In the week ahead, it’s on to the Democrat convention which may be a lot calmer!

Major global economic events and implications

US data was on a roll. Housing data was strong (with solid readings for home builder conditions, starts, sales and home prices), jobless claims remain very low, leading indicators rose more than expected and the Markit manufacturing PMI rose solidly in July. So much for all the waffle about a US recession! The US housing recovery likely has a long way to go as housing starts at 1.2 million continue to run below underlying demand of 1.5 million with the overbuilding of last decade having been more than worked off. Buying a house in Detroit still looks like a good proposition! 

Evidence is continuing to build that US profits bottomed in the March quarter. 125 S&P 500 companies have now reported June quarter earnings to date, and so far so good, with 82% beating on earnings and 60% beating on sales. While the market expects profits to fall 3% from a year ago, this will translate into a rise in profits of 8% from the March quarter.

As expected, the ECB remained in wait and see mode at its July meeting. However, President Draghi referred to greater uncertainties in reference to Brexit and reiterated the ECB’s “readiness, willingness and ability to act” if necessary. We remain of the view that its QE program will be extended beyond its current expiry of March 2017. Eurozone business conditions PMIs and consumer confidence fell slightly in July, suggesting little impact on confidence and conditions from Brexit. They remain at levels consistent with moderate growth. Interestingly, the ECB’s bank lending survey showed an increase in demand for loans and a further easing in lending standards which is also a good sign as the survey was conducted before and after the Brexit vote.

It’s not so good for the UK where its PMI fell sharply in July as Brexit hit, adding to evidence it may be heading into recession. Just remember though that the UK is only 2.5% of world GDP.

Japan’s manufacturing conditions PMI showed a welcome improvement in July albeit it’s still weak.

The Chinese property market recovery remains a positive for growth – with residential property prices up another 0.8% in June or 7.8% year-on-year. Meanwhile, the MNI Chinese business sentiment index rose in July and significant flooding in parts of China could have a short-term positive impact on GDP from rebuilding and may temporarily boost food prices.

Australian economic events and implications

In Australia, the minutes from the RBA’s last Board meeting confirmed that the door is wide open for another rate cut at its August 2 meeting. While not as direct as the Reserve Bank of New Zealand, the RBA indicated that it was waiting on further information on inflation, the labour market and the housing market and the next update of the RBA’s economic forecasts. Since it has described the labour market and the housing market as “mixed”, and recent data on both suggest no reason to change that assessment, the implication from the RBA is that should we see another low inflation reading when the June quarter CPI numbers are released on Wednesday. And then it’s likely that the RBA will cut the cash rate from 1.75% to 1.5% on August 2. A CPI outcome of 0.4% quarter-on-quarter for headline and underlying – which is what we expect - would likely be enough to see the RBA cut again.

What to watch over the next week?

The focus in the week ahead will be on monetary policy - with June quarter inflation data in Australia providing a guide to whether the RBA will cut rates again next month and both the Fed and Bank of Japan meeting – and European banks with another round of stress tests.

In the US, we expect the Fed (Wednesday) to leave rates on hold as it seeks to gain more confidence that US growth is back on track and that the impact from Brexit will be minimal, but to indicate that it still expects to raise rates in a gradual and cautious fashion. The US money market is only implying a 10% chance of a hike in the week ahead, but the Fed may try and push up the market’s probability of a hike going forward, which is currently at just 24% for September and 45% for December. With US growth averaging around 2%, the labour market continuing to tighten with wages growth edging higher and inflation heading up towards target, we see more like a 65% chance of a hike in December. The main brake on the Fed will be if the $US rises too strongly as it amounts to a de facto monetary tightening. On the data front in the US, expect to see continuing gains in US home prices, a rise in new home sales but a fall in consumer confidence (all Tuesday), softish durable goods orders and a rise in pending home sales (Wednesday), a slight edging up wages growth (according to the June quarter employment cost index) and a bounce back in annualised GDP growth to 2.6% in the June quarter (both Friday) after just 1.1% growth in the March quarter. Earnings will also remain a focus, with over 180 S&P 500 companies to report June quarter earnings.

In the Eurozone, the focus will be on the latest ECB bank stress tests (Friday) which will indicate whether banks are sufficiently capitalised or not. Italian banks of course will be the main focus, and the stress tests should help clear the way for some of them to be recapitalised. On the data front, expect June quarter GDP (Friday) to show moderate economic growth of around 1.5% year-on-year and confidence readings (Thursday) will provide a further guide to the impact of Brexit on business confidence. Data will also be released for bank lending (Wednesday) and core inflation (Friday) is likely to have remained around 0.9% year-on-year on July.

The Bank of Japan (Friday) is likely to announce further monetary easing as the Japanese government prepares to unveil its much talked about fiscal stimulus package. While it’s doubtful this will involve “helicopter money” (ie direct BoJ financing of government spending), it is getting close. Rather, it's likely to involve further monetary easing through some combination of increased ETF and corporate debt purchases and another cut in the negative deposit rate. While Bank of Japan Governor Kuroda rejected the idea of helicopter money in June, he also rejected negative interest rates shortly before announcing them. Japanese data due Friday is expected to show continued labour market strength and a bounce in industrial production but soft household spending and inflation.

In Australia, expect another low inflation reading on Wednesday for the June quarter to clear the way for an August RBA rate cut. While headline inflation is expected to rise 0.4% quarter-on-quarter thanks to higher petrol prices and a seasonal rise in health costs, this is likely to see annual inflation drop to 1.1% year-on-year and low wages growth and competitive pressures are likely to have seen underlying inflation rise just 0.4% qoq or 1.4% yoy, which is down from 1.6% yoy in the March quarter. June credit data (Friday) is likely to show that credit growth remains moderate with the stock of lending to property investors continuing to show slower growth.

Outlook for markets

Brexit related risks, Italian bank risks, renewed $US strength as the Fed heads back towards tightening and seasonal September quarter weakness could still see more volatility in shares in the short term. However, beyond near-term uncertainties, we anticipate shares trending higher over the next 12 months helped by okay valuations, very easy global monetary conditions and continuing moderate global economic growth. 

Ultra-low bond yields (with one third of the global bond index in negative yield territory) point to a soft medium-term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity, low inflation and ongoing shocks. That said, the recent bond rally has taken yields to pathetic levels leaving them at risk of a snapback. Renewed expectations of a Fed hike may be the driver.

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

Dwelling price gains are expected to slow to around 3% over the year ahead, as the heat comes out of Sydney and Melbourne thanks to tougher lending standards and as apartment prices get hit by oversupply in some areas. Prices are likely to continue to fall in Perth and Darwin. 

Cash and bank deposits offer poor returns. 

The Australian dollar is still higher than it should be and the longer term downtrend looks likely to continue, as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed eventually resumes hiking, the risk of a sovereign ratings downgrade continues to increase, commodity prices remain in a secular downswing and the $A sees its usual undershoot of fair value. The $A is still likely to fall to around $US0.60 in the years ahead.

Eurozone shares gained 0.1% on Friday and the US S&P 500 rose 0.5%, helped by good earnings results and better-than-expected business conditions PMIs. As a result of the positive global lead, the ASX 200 futures contract rose but only by 4 points or 0.1%, pointing to a mild positive start to trade for the Australian share market on Monday. Gains are likely to be tempered by softer commodity prices, including a fall in the iron ore price, which will weigh on resources stocks.

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8 reasons for the market rebound

Monday, July 18, 2016

By Shane Oliver

It has been “risk on” again over the last week in investment markets, helped by a combination of good economic data in the US and China, good US earnings news and firming expectations of more policy stimulus in Japan. US shares rose 1.5% to a new record high, European shares (up 3.9%) and Japanese shares (up 9.2%) have recovered much or all of their Brexit losses, global shares have broken their down trend from last year’s high and Australian shares rose 3.8% to their highest for the year. Chinese shares also gained 2.6%. On top of this, commodity prices are doing okay, credit spreads have narrowed and bond yields have increased with the US 10-year yield rising 19 basis points. The Aussie dollar was little changed. 

So markets generally have moved on from the initial panic reaction seen in the days after the Brexit vote. What gives? Eight factors explain the rebound in investment markets: 

  • Global policy makers have signalled easier global monetary policy for longer post Brexit; 
  • The decline in bond yields has further improved the relative attractiveness of shares; 
  • There doesn’t seem to have been a surge in support for exiting the EU or Eurozone in other European countries post Brexit. In fact, as highlighted by the Spanish election, it may be the opposite. Note of course the rest of Europe always saw itself as far more “European” than the UK ever did; 
  • Global economic data has generally been good – there has been no sign of the much feared global recession; 
  • US profits are showing signs of bottoming, helped by a stabilisation in the $US and the oil price;
  • Investors have been more relaxed about the latest decline the value of the Chinese Renminbi or RMB - perhaps reflecting slowing capital outflows from China, foreign demand for Chinese assets, reassurance from Chinese officials that a collapse in the RMB is unlikely and a growing relaxation about fluctuations in the value of the RMB; 
  • Investors have realised that Brexit may be a long time coming and may be a Brexit lite; and
  • All the talk seems to have been bearish lately – Brexit disaster, Chinese debt, US slowing, messy Australian election - which provides an ideal springboard for market gains!

Japanese PM Shinzo Abe’s coalition’s big upper house election victory on Sunday looks to have cleared the way for more stimulus in Japan with Abe commenting “I think this means I am being told to accelerate Abenomics..” A large fiscal stimulus package looks to be on the way and expectations of more monetary easing (probably at the BoJ’s July 29 meeting) have seen the Yen fall. Japan looks to be getting close to using “helicopter money” – where the central bank directly finances public spending or tax cuts, with no implication that it has to be paid back – but it may not be used initially. 

While the Bank of England did not ease monetary policy at its July meeting, it clearly signalled easing ahead with the minutes, noting that “most members of the Committee expect monetary policy to be loosened in August.”

Meanwhile, new UK PM Theresa May’s decision to give prominent Brexit Leave campaigners the task of seeing the job through has effectively put them on the hook to explain any compromises (e.g. around immigration to maintain free trade access) or to take some of the blame if it goes wrong. There is also a long way to as Article 50 of the Lisbon treaty may not be triggered until next year and by then a weaker UK economy (owing to negative Brexit confidence effects) could have dimmed support for it. So there is still plenty of room for Brexit lite or even no Brexit. Either way, Brexit will be an ongoing issue, but I suspect markets will just learn to live with it along with all the other noise that surrounds them. The key is that if Brexit is demonstrated to be more trouble than remaining in the EU, then the risk of a domino effect of exits across the Eurozone will be much reduced.

Perhaps more fundamentally, PM May has signalled a focus on reducing the perceived injustices that helped drive the Brexit vote in the first place. While it’s clear that governments need to respond to rising inequality – particularly in the US and UK where its most evident – or face longer term risks, the danger is that a shift away from economic rationalist policies will ultimately threaten productivity and growth and hence investment returns much as it did in the 1970s.

Geopolitical risk reared its head again in the last week in relation to South China Sea tensions, another terrorist attack in France, and a coup attempt in Turkey: 

  • The decision by UN’s Permanent Court of Arbitration in favour of the Philippines in relation to disputed “islands” in the South China Sea signals a step up in geopolitical risks in the region. This was particularly so after China’s Foreign Ministry declared the decision “null and void” and there was talk of China having the right to declare an Air Defence Identification Zone (ADIZ) in the area. But an ADIZ was declared by China over disputed islands with Japan in 2013 and not enforced. Also, China’s Foreign Minister indicated a willingness to peacefully resolve the dispute through negotiations which the new more pro-China president of the Philippines may be amenable to. There are lots of risks in the South China Sea, but this could drag on for years and come to nothing despite occasional flare ups.
  • The latest horrible terrorist attack in France had a muted impact on the French share market on Friday (-0.3%) and on travel shares, but it is noteworthy that financial markets seem to be getting used to such attacks with the impact of recent past terror attacks being short lived.
  • News of an attempted coup in Turkey (with the army saying it’s taking power to restore democracy and freedom) adds further to geopolitical risks given the regional hot spot Turkey sits in. But it’s at least the fourth coup in Turkey since 1960, and I suspect no lasting impact on global markets. It’s not good for Turkey though.

Major global economic events and implications

US economic data was good with stronger than expected gains in retail sales and industrial production, a slight rise in small business optimism and continued strong data on job openings (albeit down slightly) and hiring and ultra-low jobless claims. Core CPI inflation rose 2.3% over the year to June, adding to evidence that deflationary risks are receding and implying a 1.6% year-on-year increase in the core private consumption deflator. Fed officials have been sounding more relaxed about the US economy after the jobs data and regarding the impact of Brexit, with the implication that the Fed is still on track for one rate hike this year. The US money market’s probability of a hike this year has now increased to 45% up from just 12% pre payrolls but still looks too low. That said, the reality or threat of a rising US dollar will act as a strong constraint on how much the Fed will tighten.

Weak Japanese machine orders and wages growth highlight the pressure for further policy stimulus in Japan.

Chinese growth has stabilised. June quarter GDP growth was unchanged at 6.7% and while June data showed that investment and imports slowed, growth in industrial production, retail sales, credit and money supply all came in better than expected and mostly picked up. So, after a long period of deceleration, Chinese growth looks to be stabilising just above 6.5%, which is good for commodity prices and hence Australia. Meanwhile, producer price deflation continues to recede which is a good sign, but CPI inflation remains very low (just 1.2% year-on-year for non-food inflation) indicating plenty of scope for ongoing policy stimulus.

Australian economic events and implications

Australian economic data was okay. While consumer confidence fell presumably in response to the messy election result, Brexit, etc, the fall was only 3% and leaves confidence at the high end of the range of the last few years. Meanwhile, business conditions in June (albeit pre-election) were solid, home loans rose in May leaving in place just a moderately slowing trend, housing starts rose to a record in the March quarter and jobs growth continued in June. Our assessment remains that the RBA will cut rates again next month but with okay economic data it’s dependent on another low June quarter inflation reading due on July 27th. Falling retail prices in the June NAB survey certainly point in this direction.

What to watch over the next week?

In the US, expect another solid reading for the NAHB home builders’ conditions index (due Monday), gains in housing starts and permits to build new homes (Tuesday), a further rise in home prices but a slight fall in existing home sales (both Thursday) and a slight increase in the Markit manufacturing conditions index for July to around 51.5 (Friday). The Republican convention (July 18-21) in Cleveland will see the focus on the November presidential election ramp up.

The US June quarter earnings reporting season will also start to ramp up, with over 100 S&P 500 companies due to report. While the consensus sees a 4% decline in earnings from the June quarter a year ago, this will mark roughly a 7% gain in earnings from the March quarter, with a more stable US dollar and oil price helping. In other words, the US earnings recession could be over.

The European Central Bank is expected to make no changes to monetary policy when it meets Thursday as it’s still in “wait and see” mode after the further easing it announced earlier this year. However, it’s likely to remain dovish and indicate that it is closely monitoring the risks flowing from Brexit and around Italian banks. An extension to its quantitative easing (beyond March 2017) and bank liquidity assistance programs (TLTRO) is likely at some point. Meanwhile, July business conditions PMIs (Friday) will be watched for any impact from the Brexit vote, but are expected to remain reasonable.

Japan’s manufacturing PMI for July (Friday) will be watched for an improvement from the low reading of 48.1 in June.

In Australia, the minutes from the last RBA Board meeting are likely to imply that the door is open to another rate cut should June quarter CPI data due on July 27 confirm that inflation remains lower than desired. Data on skilled vacancies will also be released.

Outlook for markets

Brexit related risks, Italian bank risks, renewed US dollar strength as the Fed heads back towards tightening, and seasonal September quarter weakness could still see more volatility in shares in the short term. However, beyond near term uncertainties, we anticipate shares trending higher over the next 12 months helped by okay valuations, very easy global monetary conditions and continuing moderate global economic growth. 

Ultra-low bond yields (with one third of the global bond index in negative yield territory) point to a soft medium-term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity, low inflation and ongoing shocks. That said, the recent bond rally has taken yields to pathetic levels leaving them at risk of a snapback. Renewed expectations of a Fed hike may be the driver.

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

Dwelling price gains are expected to slow to around 3% over the year ahead, as the heat comes out of Sydney and Melbourne thanks to toughening lending standards and as apartment prices get hit by oversupply in some areas. Prices are likely to continue to fall in Perth and Darwin. 

Cash and bank deposits offer poor returns. 

The Australian dollar is still higher than it should be and the longer term downtrend looks likely to continue as the interest rate differential in favour of Australia narrows; as the RBA continues cutting and the Fed eventually resumes hiking, the risk of a sovereign ratings downgrade continues to increase, commodity prices remain in a secular downswing and the Aussie dollar sees its usual undershoot of fair value. The Aussie dollar is still likely to fall to around $US0.60 in the years ahead.

Eurozone shares fell 0.2% on Friday and the US S&P 500 lost 0.1% despite good US economic data, possibly reflecting a bit of profit taking after recent gains. Reflecting the soft global lead, the ASX 200 futures fell 11 points or 0.2% pointing to a soft start to trade on Monday. This may be accentuated a bit by news of a Turkish coup attempt which broke after the US share market closed, but did see US S&P 500 futures slip 0.4%. 

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Will Brexit ever happen?

Monday, July 11, 2016

By Shane Oliver

Wariness returned to investment markets in the past week, led in part by worries about Italian banks, but this was reversed to some degree on Friday by strong US jobs data. As a result share markets were mixed over the week with Eurozone shares down 1.6%, Japanese shares down 3.7% (not helped by the rising Yen) and Australian shares down 0.3%. But US shares rose 1.3% (to around a record high) and Chinese shares rose 1.2%. Worries about Australian banks - on the back of global bank weakness, APRA indications further capital raising may be required, and the shift in Australia’s and banks’ credit rating outlook to “negative” by Standard and Poors - weighed on the Australian share market.

Bond yields continued to fall and a rising $US weighed on oil and metal prices and saw the Chinese Renminbi fall to its lowest level since 2010. Despite the rising $US and S&P placing Australia’s credit rating on negative outlook, the $A rose.

Fears around a recession in the UK following the Brexit decision continue to build, with business confidence falling sharply. Clearly UK business is concerned about their continued access to EU markets. These concerns have also hit the UK commercial property market with several unlisted property funds halting redemptions as investors anticipate a bleak outlook for the UK property market if businesses decide to relocate operations to Europe. While the Bank of England cut banks’ capital requirements and the continuing plunge in the value of the British pound should help, it’s doubtful this will be enough to stop a recession later this year. Bear in mind though that the UK economy is only 2.5% of global GDP. It’s also worth noting that the problem with British property funds are reflective of a specific problem in the UK post Brexit. It’s not indicative of a problem with global commercial property markets generally.

But will Brexit even happen? Given the Bregret and mayhem in the UK there is some chance that Article 50 of the Lisbon treaty, which governs exits from the EU will never be triggered. This could happen say if the new conservative leader waits till next year to trigger Article 50, by which time a recession could have moved popular opinion against Brexit, or alternatively, if a new election is called which becomes another defacto referendum on Brexit. It’s also possible that the UK does trigger Article 50, but then in negotiating with the rest of the EU concludes it doesn’t want to go.

While once triggered Article 50 supposedly means no going back, it’s likely that in this circumstance the EU will find a way to keep the UK in. All of this has a long way to play out though. Of course, the real issue for the global economy and investment markets is the impact on Europe and the risk of a domino effect of exiting Eurozone countries. But if Britain ultimately doesn’t leave, or leaving is demonstrated to be more trouble than remaining, then the risk of a domino effect will be much reduced.

But back to the present, in the Eurozone the main focus regarding post-Brexit risks in the past week relates to European – mostly Italian - banks. These have been weakened by years of slow growth, ultra-low interest rates and tighter regulatory conditions. These risks preceded Brexit, but the Brexit scare has refocused attention on them by pushing down bank share prices, which in turn, makes it harder for banks to raise capital. Italian banks are arguably most at risk with the Italian government wanting to recapitalise some of them, but the European Commission preferring a bail-in from creditors. Not recapitalising them risks slower bank lending, slower growth and higher unemployment and hence a greater risk of support for a move out of the Eurozone in countries like Italy. At this stage, we are a long way from this and some sort of muddle through solution will likely be found. But of course it won't stop investors worrying about it in the interim.

On the positive side of the equation, it's notable that Italian and Spanish bond yields remain around record lows, suggesting the threat of ECB intervention is working, the latest rise in the value of the $US and associated fall in the Chinese Renminbi has not been associated with the panic around capital outflows from China that we saw earlier this year, and commodity prices continue to hold up reasonably well which may be a good sign for global growth. But again, it's early days yet, and one risk worth keeping an eye on is that of a further rise in the $US. Ongoing upwards pressure on the $US is a real risk, given the risk of safe haven flows out of Europe at the same time that the US economy looks to be doing okay (as confirmed by strong June employment gains which suggests a much greater chance of a Fed hike this year than the 21% probability that the US money market is assigning). Another break higher in the $US would be bad for oil and other commodities, the emerging world, and the Chinese Renminbi.

In Australia, the Coalition will be returned to government. The issue of course is that the Senate is likely to be less friendly than over the last three years, which will mean the Coalition Government will have little chance of passing key aspects of this year’s Federal Budget including its company tax cuts (at least not for large companies), some of its superannuation changes and the still to be passed savings from the 2014 budget. The likelihood would be more slippage in the return to budget surplus. Serious economic reform looks off the agenda. 

Reflecting the risk of yet more budget slippage, its little surprise to see the ratings agencies getting tetchy, with Standard and Poors putting Australia’s sovereign rating on negative outlook. This of course does not mean a downgrade is inevitable, but with the new parliament “unlikely to legislate savings or revenue measures sufficient….for the budget deficit to narrow materially” [in the words of S&P], I would say that it’s probable. So far the financial markets have taken the move to negative outlook calmly perhaps because it has long been talked about. In theory, a ratings downgrade should mean higher interest rates as foreigners demand a higher yield on Federal debt and this flows through to state debt, banks, corporates and potentially to out of cycle mortgage rate hikes for households. In reality, this impact may be muted. The US in 2011 and the UK last week actually saw bond yields fall after ratings downgrades and many lower rated countries borrow more cheaply than Australia (eg, Italy and Spain). And in any case the RBA can still offset higher mortgage rates with another interest rate cut.

Rather the biggest concern about the threat to our AAA rating is what it tells us about policy making in Australia today. Australia worked hard reforming the economy after last being downgraded in 1986 and won a AAA rating back in 2002. Losing it again would signal we have become unable to control public spending, that we have lost our way to some degree after the hard work of the Hawke/Keating & Howard/Costello years.

Major global economic events and implications

US economic data was good, with a very strong rebound in June payroll employment, continuing low jobless claims and the ISM non-manufacturing index rising to a solid 56.5 in June. The June payroll employment gain of 287,000 more than makes up for the weak May gain. Abstracting from monthly noise, jobs growth averaged a solid 147,000 a month over the last three months telling us that the US economy is doing well. The Fed will probably still want to see more evidence that US growth has picked up sustainably and that global risks post Brexit are settling down, and so won’t be rushing to raise rates soon, particularly with wages growth remaining low. However, given the solid June payroll report, we remain of the view that the Fed will raise rates again this year, probably in December. The US money markets’ assessment of just a 21% chance of a Fed hike this year (up from 12% pre payrolls) is way too pessimistic and will likely move up, which in turn, will place upwards pressure on bond yields at some point by year end. 

Japan’s poor PMI readings, falling wages and a 20% rise in the Yen since last year’s high, add to pressure on the Bank of Japan. Expect BoJ easing and intervention to push the Yen down soon.

China’s services PMI improved in June, consistent with okay growth with services continuing to lead over manufacturing.

Australian economic events and implications

In Australia, the RBA opened the door to another rate cut, indicating that it was awaiting “further information” which is presumably a reference to June quarter inflation data later this month. We remain of the view that the RBA will cut rates again as the risks to inflation are on the downside, the risks to global and Australian growth are still on the downside (with Brexit and the messy Australian election not helping) and the $A is still too high. We are continuing to allow for two more 0.25% rate cuts this year, the first in August.

Australian data was on the soft side with a fall in building approvals and slowing momentum in retail sales, but ANZ job ads still pointing to reasonable jobs growth. National house price momentum slowed in June, but remains lopsided with strength in Sydney and Melbourne but four capitals seeing falls.

What to watch over the next week?

In the US, expect a modest gain in June retail sales, a slight improvement in industrial production and core CPI inflation around 2.2% year on year (all Friday). Alcoa will kick off June quarter earnings reports on Monday. The consensus sees a 5% decline in earnings year-on-year, but this will mark a rise on the March quarter, with a more stable $US and oil price helping.

Expect the Bank of England to ease monetary policy on Thursday.

In China, June quarter GDP is likely to show a softening in growth to 6.6% from 6.7% (Friday). However, the quarterly rate of growth is expected to perk up. Export and import data will also be released and data for industrial production, retail sales and investment may show a slight slowing.

In Australia, expect a fall in housing finance (Monday), little change in business conditions in the June NAB business survey (Tuesday), a small fall in consumer confidence (Wednesday) on the back of Brexit and election noise and a 10,000 gain in jobs, but a slight rise in unemployment to 5.8% (Thursday).

Outlook for markets

Brexit uncertainty, Italian bank risks, renewed $US strength and seasonal September quarter weakness could see more volatility in shares in the short term. However, beyond near-term uncertainties, we still see shares trending higher this year, helped by okay valuations, very easy global monetary conditions and continuing moderate global economic growth. 

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

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

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

Cash and bank deposits offer poor returns. 

The Australian dollar is still higher than it should be and the longer term downtrend looks likely to continue as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed eventually resumes hiking, the risk of a sovereign ratings downgrade continues to increase, commodity prices remain in a secular downswing and the $A sees its usual undershoot of fair value. The $A is still likely to fall to around $US0.60 in the years ahead. 

Eurozone shares gained 2.1% on Friday and the US S&P 500 rose 1.5% to around its record high. As a result of the strong global lead, ASX 200 futures rose 61 points or 1.2% pointing to a solid gain for the Australian share market when it opens on Monday.

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Will we see a post-election rally?

Monday, July 04, 2016

By Shane Oliver

Share markets rebounded over the past week as worries about Brexit leading to global financial and economic chaos faded. US shares rose 5.1%, Eurozone shares gained 3.9%, Japanese shares rose 4.9%, Chinese shares rose 2.5% and the Australian share market gained 2.6%. Despite ongoing political turmoil in the UK, the British share market surged 7.2% to its highest for the year helped by the plunging British pound and talk of Bank of England monetary easing. Bond yields continued to decline on lower for longer interest rate expectations but currency markets were a bit more stable (apart from the pound), credit spreads narrowed and commodity prices rose.

There have been several positive developments over the last week with respect to Brexit. Well maybe not for the UK, but in terms of the issue that really matters and that is the threat it poses to the rest of Europe and the global economy. First, the Spanish election actually saw support for the governing People’s Party increase with no gain for anti-establishment Podemos suggesting that the Brexit mayhem may have seen voters opt for stability. Of course, PM Rajoy’s People’s Party still has to form a coalition government but the prospects are much higher than after the December election.

Second, two clear messages emerged from the European Union leader’s summit in the last week: it is looking to learn the lessons from the UK’s exit to better serve its citizens and strengthen the EU; and it is taking a firm stance with the UK – there can be no access to the benefits of free trade with the EU without meeting the obligations (the free movement of people, adoption of EU rules and regulations and contributing to its budget). In other words, the UK will not be let off lightly which will send a strong signal to other potential exiteers. 

Third, policy makers around the world have continued to swing into action with the Bank of England foreshadowing monetary easing, talk that the ECB is considering expanding its bond purchases, fresh stimulus in Korea, another rate cut in Taiwan and more moves towards stimulus in Japan.

Fourth, bond yields in Spain and Italy have fallen sharply to new record lows indicating that so far investors are not demanding a higher premium to invest in such countries. The threat of ECB “whatever it takes” intervention to preserve the Euro is helping.

Finally, assets vulnerable to a rising $US have not crashed. In fact, oil has hung around $US50, copper is up and emerging market shares are OK. Credit spreads have not blown out. We don’t seem to be seeing a re-run of the January-February panic. 

Of course, the ride will remain rough for UK assets, although the British pound appears to be wearing the worst of that and it should be borne in mind that the UK is only 2.5% of global GDP. And uncertainty will remain regarding the risk of a domino effect of exits in the Eurozone - with the Italian Senate referendum in October and a re-run of the Austrian presidential election in September or October following a ruling by the Austrian Constitutional Court being the next big events to watch. But so far at least, the threat from Brexit to the Eurozone and the rest of the world looks to be constrained.

In Australia, the election is finally over but it looks like another three years of de facto minority government which is not a great outcome for the economy and investment markets. While the Coalition looks to be slightly ahead in the seat count so far, it looks very close and the outcome may not be known till Tuesday at the earliest. Even if the Coalition does win government, it won’t have control of the Senate with the balance of power remaining with the Greens and minority “parties” which will act as a huge constraint on the government, which means another de facto minority government, ie, more of the same. The end result will be poor prospects for getting government spending and the budget deficit under control over the next three years and for the Coalition implementing its policy to cut corporate taxes let alone undertaking serious productivity enhancing economic reforms. It looks next to impossible for a Coalition government to get enough votes to reinstate the Australian Building and Construction Commission.

Alternatively, if Labor wins it will likely mean faster public spending growth via more spending on health and education, partly funded by tax increases on higher income earners (retention of the budget deficit levy and cutbacks in access to negative gearing and the capital gains tax discount and superannuation savings similar to those of the Coalition, although the details haven’t been spelt out) but a higher budget deficit in the next few years, a royal commission into banking, and greater intervention in the economy.

The prospect of another three years of de facto minority government coming on the back of the minority Gillard/Rudd government over 2010-13 and the 2013-16 Coalition government’s inability to pass much of its economic and budget reform agenda through the Senate is not a good outcome for the Australian economy. Whoever wins, it means that the risk of a sovereign credit rating downgrade has increased further.

More broadly, the success of Labor's campaign offering more spending and higher taxes coming on the back of the Brexit outcome in the UK and the success of Trump and Sanders in the US adds to evidence that median voters are shifting to the left and away from the economic rationalist policies of deregulation, smaller government and globalisation. This is a negative for long-term growth prospects and an additional constraint on investment returns.

Over the 8 weeks since the election was called, Australian shares fell 0.6%. The next table shows that shares rose an average 4.8% over the 3 months after the last 12 Federal elections with 8 out of 12 seeing gains. Will we see a post-election rally over the next 3 months this time around? Relief at getting the election out of the way may help, but the unclear outcome with the likelihood of minority government and the failure of the new government to have control of the Senate, September quarter seasonal weakness in shares and Brexit uncertainty are likely to weigh in the short term, even though I see shares being higher by year end.

Major global economic events and implications

US economic data was good with a surprisingly solid increase in the June manufacturing conditions ISM index, good growth in consumer spending for the second month in a row in May, a rise in consumer confidence, continued gains in home prices, the June services PMI flat at 51.3 and continuing low jobless claims. While pending home sales and trade data were weaker than expected, March quarter GDP growth was revised up to 1.1% annualised and June quarter growth looks to have rebounded to around 3% annualised.

Eurozone economic sentiment fell only slightly in June and remains consistent with moderate growth and a pick-up in bank lending growth is a positive sign. Inflation rose slightly in June but remains low at 0.1% year-on-year for headline and 0.9% year-on-year for core.

Japanese jobs data for May remained strong, housing starts rose and the June quarter Tankan business conditions survey was little changed, but May data for household spending and industrial production were soft and core inflation slipped further to just 0.6% year-on-year, adding to pressure for more stimulus.

Chinese business conditions PMIs for June were little changed consistent with growth running around 6.5% to 7%.

Australian economic events and implications

In Australia, early indications of the impact of the Brexit outcome on confidence suggest little impact with the ANZ/Roy Morgan weekly consumer sentiment reading falling just 1.7% to a level still above its long term average and auction clearance rates remaining solid. Meanwhile, job vacancies fell over the 3 months to May but on an annual basis still point to solid jobs growth, private credit growth slowed in May with credit to property investors continuing to lose momentum and business lending slowing, home price growth slowed in June with four capital cities seeing price declines but Sydney and Melbourne remaining strong, new home sales fell in May and the AIG’s manufacturing PMI improved to an okay 51.8.

What to watch over the next week?

The week ahead will no doubt see bouts of Brexit related nervousness but it may continue to settle down in the absence of any new developments in Europe. In Australia we will see reaction to the election result, but if its more of the same then the impact will be minor.

In the US, June payroll employment (Friday) is likely to bounce back by 180,000 jobs after the disappointing May gain of 38,000 with unemployment remaining at 4.7% and wages growth running around 2.6% year-on-year. But given the threat to confidence and growth from Brexit it won’t be enough to signal an imminent Fed rate hike in July. It will help ease fears regarding US growth though. Meanwhile, expect the non-manufacturing conditions ISM for July to remain around an OK 52.9 but the May trade deficit to deteriorate a bit given preliminary goods trade data (both Wednesday). The minutes from the last Fed meeting (also Wednesday) are likely to be very dovish but are dated given the Brexit outcome.

Chinese CPI inflation (Sunday July 10) for June is likely to have remained around 2% year-on-year, but producer price deflation is likely to show a continued abatement.

In Australia, expect the RBA (Tuesday) to leave interest rates on hold for the second month in a row. Following its last meeting the RBA expressed a degree of comfort with current interest rate settings and while Brexit and Australian election related risks have added to the case for another rate cut at this stage the RBA is likely in wait and see mode. That said we still expect further easing this year with the August meeting providing a better opportunity to move as by then the risks flowing from Brexit and the Australian election will be clearer and we will have seen the June quarter inflation data.

In the meantime expect a sharp fall in May building approvals (Monday) after several months of strength and continued moderate growth in retail sales (Tuesday). ANZ job ads, the May trade deficit and the services PMI will also be released.

Outlook for markets

Brexit uncertainty and seasonal September quarter weakness could see more volatility in shares in the short term. The messy Australian election outcome is also likely to weigh on Australian shares in the short term. However, beyond near term uncertainties, we still see shares trending higher this year helped by relatively attractive valuations, very easy global monetary conditions and continuing moderate global economic growth. 

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

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

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

Cash and bank deposits offer poor returns. 

The Australian dollar is still higher than it should be and the longer term downtrend looks likely to continue as the interest rate differential in favour of Australia narrows (as the RBA continues cutting and the Fed eventually resumes hiking, the risk of a sovereign ratings downgrade continues to increase, commodity prices remain in a secular downswing and the $A sees its usual undershoot of fair value). The dollar is still likely to fall to around $US0.60 in the years ahead.

Eurozone shares gained 0.6% on Friday and the US S&P 500 rose 0.2% as Brexit related fears continued to recede. While ASX 200 futures rose 32 points or 0.6% following the positive global lead and rising commodity prices, this is likely to be more than offset by the messy Australian election outcome suggesting that Australian shares could see a modest fall at the open. Put simpl,y markets don’t like policy uncertainty and the election has delivered that. The election outcome and the prospect of a ratings downgrade could also push the $A down. 

 

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Keeping Brexit in perspective

Monday, June 27, 2016

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

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

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

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

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

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

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

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

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

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

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

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

Now on to other things!

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

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

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

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

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

Australian shares before and after elections

Major global economic events and implications

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

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

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

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

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

Australian economic events and implications

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

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

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

What to watch over the next week?

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

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

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

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

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

Outlook for markets

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

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

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

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

Cash and bank deposits offer poor returns.

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

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

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Is the Brexit frenzy justified?

Monday, June 20, 2016

By Shane Oliver

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

Source: Global Financial Data, AMP Capital

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

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

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

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

Source: US Federal Reserve, AMP Capital

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

Major global economic events and implications

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

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

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

Australian economic events and implications

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

What to watch over the next week?

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

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

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

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

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

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

Outlook for markets

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

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

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

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

Cash and bank deposits offer poor returns. 

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

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

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Brexit blues

Wednesday, June 15, 2016

By Shane Oliver 

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

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

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

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

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

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

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

Australian bond yields at record lows

Source: Global Financial Data, Bloomberg, AMP Capital 

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

Record low cash rates driving record low bond yields

Source: Bloomberg, AMP Capital

Major global economic events and implications

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

Australian economic events and implications

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

What to watch over the next week?

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

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

Outlook for markets

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

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

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

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

Cash and bank deposits offer poor returns. 

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

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

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Has Janet Yellen lost her nerve?

Monday, June 06, 2016

By Shane Oliver

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

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

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

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

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

Has China really overinvested?

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

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

Major global economic events and implications

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

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

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

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

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

Australian economic events and implications

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

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

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

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

What to watch over the next week?

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

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

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

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

Outlook for markets

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

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

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

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

Cash and bank deposits offer poor returns. 

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

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Why a Brexit is a bad idea

Monday, May 30, 2016

By Shane Oliver

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

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

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

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

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

Is the Brexit risk receding?

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

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

Perhaps this logic is starting to set in.

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

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

Major global economic events and implications

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

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

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

Australian economic events and implications

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

Source: ABS, AMP Capital

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

Source: ABS, AMP Capital

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

What to watch over the next week?

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

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

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

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

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

Outlook for markets

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

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

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

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

Cash and bank deposits offer poor returns. 

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

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Will Janet Yellen pull the trigger on interest rates?

Monday, May 23, 2016

By Shane Oliver

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

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

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

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

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

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

Source: ABS, AMP Capital

Major global economic events and implications

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

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

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

Australian economic events and implications

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

What to watch over the next week?

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

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

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

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

Outlook for markets

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

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

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

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

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

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

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