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

3 ways the North Korean issue could unfold

Monday, August 14, 2017

By Shane Oliver

Share markets fell over the last week on the back of escalating fears around conflict with North Korea. US shares fell 1.4%, Eurozone shares lost 2.6%, Japanese shares fell 1.5%, Chinese shares lost 1.6% and Australian shares fell 0.5%. Bonds benefitted from a flight to safety and continuing low inflation readings in the US, pushing yields down slightly. Commodity prices were mixed though, with oil down but copper, iron ore and gold up. While the $US fell against the Yen and the Euro, the $A fell against all three.

North Korean risks ramp up

North Korean risks have clearly ramped up significantly over the last week, as the UN Security Council agreed on more sanctions; reports suggested it may already have the ability to put a nuclear weapon in an intercontinental ballistic missile; President Trump threatened it with “fire, fury and, frankly, power..” only to add a few days later that that “wasn’t tough enough” and that “things will happen to them like they never thought possible”; and North Korea talked about plans to fire missiles at Guam.

Source: AAP

This all reminds me of something out of James Bond (or rather Austin Powers) except that its serious and naturally has led to heightened fears of an imminent military conflict. Of course it could all de-escalate again, but given North Korea's growing missile and nuclear capability, it does seem that the North Korean issue after years of escalation and de-escalation may come to a head soon. In thinking about the risks around North Korea, it’s useful to think in terms of three scenarios as to how it could unfold:

1. Diplomacy/no war – sabre rattling would likely intensify further before a resolution is reached, during which share markets could correct maybe 5-10% before rebounding once it becomes clear that a peaceful solution is in sight. An historic parallel is the Cuban Missile Crisis of October 1962 that saw US shares fall 7% before a complete recovery after the crisis was resolved. 

2. A brief and contained military conflict - perhaps like the 1991 and 2003 gulf wars proved to be, albeit without a full-on ground war or regime change. In both gulf wars, while share markets were adversely affected by nervousness ahead of the conflicts, they started to rebound just before the actual conflicts began.

3. A significant military conflict – a contained gulf war style military conflict is unlikely as North Korea would most likely launch missile attacks against South Korea (notably Seoul) and Japan, causing significant loss of life. This would entail a more significant impact on share markets with say 20% or so falls before it became clear that the US would prevail. 

Diplomacy remains by far the most likely path. The US is aware of the huge risks in terms of the potential loss of life in South Korea and Japan that would follow if it acted pre-emptively against North Korea and it is not interested in regime change there. And North Korea appears to only want nuclear power as a deterrent. In this context, Trump’s threats along with the US’ show of force earlier this year in Syria and Afghanistan are designed to warn North Korea of the consequences for them of an attack on the US or its allies, not to indicate that an armed conflict is imminent. Rather, US officials are still working on a diplomatic solution.

As such, our base case remains that there is a diplomatic solution, but there could still be an increase in uncertainty and share market volatility in the interim and the risk is significant (particularly given the volatile personalities of Kim Jong-un and Donald Trump). Key dates to watch are North Korean public holidays on August 15 and 25 and September 9, which are often excuses to test missiles, and US-South Korean military exercises starting August 21.

More broadly, the intensification of the risks around North Korea comes at a time when there is already a significant risk of a global share market correction. The recent gains in the US share market have been increasingly concentrated in a few stocks; volatility has been low and short-term investor sentiment has been high indicating a degree of investor complacency; political risks in the US may intensify as we come up to the need to avoid a government shutdown and raise the debt ceiling next month (which will likely see the usual brinkmanship ahead of a solution); market expectations for Fed tightening look to be too low (with only a 25% probability of a hike priced by December); tensions may return to the US-China trade relationship; and we are in the weakest months of the year seasonally for shares.

While Australian shares have already had a 5% correction from their May high, they are nevertheless vulnerable to any US/global share market pull back. However, absent a significant and lengthy military conflict with North Korea (which we think is unlikely) we would see any pullback in the next month or so as just a correction rather than the start of a bear market. Share market valuations are okay – particularly outside of the US, global monetary conditions remain easy, there is no sign of the excesses that normally presage a recession and profits are improving on the back of stronger global growth. As such, we would expect the broad rising trend in share markets to resume through the December quarter and into 2018.  

Major global economic events and implications

US data remains solid with small business optimism rising in July and around as high as it ever gets, job openings rising to a record and jobless claims remaining ultra low. All at the same time, producer and consumer price inflation remains soft, with the core CPI stuck at 1.7% year-on-year (yoy) in August. Strong growth readings keep the Fed on track to continue tightening, with a start to winding back quantitative easing next month, but low inflation will keep it gradual.

The US June-quarter earnings reporting season is now 90% done, with 78% beating on earnings, 68% beating on sales and earnings up around 11% yoy. 

Earnings growth seen in the June quarter is even stronger in Europe at 35% yoy and Japan at 37% yoy.

Chinese export and import growth slowed a bit more than expected in July but remains consistent, with GDP growth running around 6.5-7% year on year. Inflation data for July was benign with 1.4% yoy consumer price inflation and 5.5% yoy producer price inflation, neither of which have any significant implications for monetary policy.

Australian economic events and implications

RBA Governor Lowe’s Parliamentary testimony provided no real surprises and basically repeated the themes of RBA commentary released over the last two weeks. However, he highlighted the issues around low wages growth, noted that the RBA is continuing to watch consumer spending and the housing markets in Sydney and Melbourne very closely and reiterated his warning that the appreciation in the Australian dollar is weighing on inflation and growth and that a lower $A would be “helpful”.

RBA Governor, Philip Lowe. Source: AAP.

While Lowe indicated that the next move in rates is more likely to be up than down, he also indicated that this won’t be for some time. Our view remains that rates will remain on hold ahead of a rate hike late next year, but if the $A continues to rise, rate hikes will be even further delayed and the next move could turn out to be a cut. At this stage, Governor Lowe appears to be happy with the tightening in mortgage lending standards, but with a further cooling in Sydney and Melbourne still needed, we think additional measures cannot be ruled out. 

Australian economic data

Australian data was the usual mixed bag, with solid readings for ANZ job ads, and business conditions and confidence according to the NAB business survey for July, and a slight rise in housing finance commitments but a further decline in consumer confidence. The gap between upbeat business confidence and down beat consumers is widening and remains a bit perplexing. The combination of record low wages growth, rising energy costs, increases in some mortgage rates and worries about having too much debt are all weighing on Australian households.

While low wages growth may be good for profits and business, subdued consumer confidence will weigh on consumer spending going forward. Better jobs growth should help eventually push up wages growth and hence consumer confidence, but as we have seen globally, the lags are long these days. All of which supports the case for the RBA to keep interest rates down for some time to come.

Source: NAB, Westpac/Melbourne Institute, AMP Capital

Reporting season

It's early days in the June-half earnings reporting season, as only 25 or so major companies have reported, but so far it’s been mixed. 45% of results have exceed expectations, which is around the long term norm of 44% (see the first chart below), but 72% have reported profits higher than a year ago and 82% have increased dividends from a year ago. But, reflecting the mixed results so far, 50% of companies have seen their share price outperform the market on the day they reported and 50% have seen underperformance. It’s worth noting though that there is a tendency for the quality of results to tail off a bit as the reporting season proceeds. Consensus earnings expectations for 2016-17 have been revised down by 0.4% to 17.7% over the last week, but mainly due to resources stocks.

Source: AMP Capital

Source: AMP Capital

Source: AMP Capital

What to watch over the next week?

In the US, the minutes from the Fed’s last meeting (Wednesday) are likely to firm expectations that the Fed will announce the start of letting its balance sheet run down next month (basically quantitative tightening) but signal that sub target inflation means a degree of uncertainty around the timing of the next interest rate hike (which we expect to be in December). On the data front, expect gains in retail sales and the NAHB home builders’ conditions index (both Tuesday), housing starts (Wednesday) and industrial production (Thursday) and solid readings for the New York and Philadelphia manufacturing conditions indexes.

Japanese June quarter GDP data (Monday) is expected to show a bounce in growth to 0.6% quarter on quarter or 2.5% year on year driven by consumer spending and investment.

Chinese activity data for July is expected to show a slight slowing after the acceleration seen in June, with retail sales growth slowing to 10.8% year, industrial production slowing to 7.2% and fixed asset investment unchanged at 8.6%.

In Australia, the minutes from the RBA’s last board meeting (Tuesday) are likely to show the Bank firmly on hold with most interest likely remaining on how the RBA sees the recent rise in the Australian dollar. Speeches by RBA officials Kent and Ellis will be watched for any additional clues on interest rates. On the data front, the focus will be on the labour market with June quarter wages data (Wednesday) expected to show that wages growth remains soft at 0.5% qoq or 1.9% yoy and July labour force data (Thursday) expected to show a 10,000 gain in jobs and unemployment remaining around 5.6%.

The August profit reporting season will speed up in the week ahead, with around 60 major companies reporting including Bendigo Bank, Ansel and JB Hi Fi on Monday, GPT on Tuesday, Westfield, Origin, Fairfax, Seek and Woodside on Wednesday and Wesfarmers, QBE and Telstra on Thursday. 2016-17 profits for the market as a whole are likely to have increased by around 18%, driven by a huge 133% gain in resources profits on the back of the rebound in commodity prices. Profit growth for the rest of the market is likely to be around 5.5% led by retailers, utilities, healthcare stocks and financials. Dividends and outlook statements will remain the key focus.

Outlook for markets

Share markets are at risk of a short-term correction, with signs of short-term investor complacency in the US share market and various potential triggers including risks around North Korea, US politics and the Fed. However, with valuations remaining okay – particularly outside of the US, global monetary conditions remaining easy and profits improving on the back of stronger global growth, we would see a pullback as just a correction with the broad rising trend in share markets likely to resume through the December quarter and into 2018.  

Low yields point to ongoing low returns from bonds.  

Unlisted commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this will wane eventually as bond yields trend higher. 

National residential property price gains are expected to slow, as the heat comes out of Sydney and Melbourne. 

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.

While further short term upside in the $A is possible, our view remains that the downtrend from 2011 will ultimately resume as the interest rate differential in favour of Australia is likely to continue to narrow as the Fed hikes rates and the RBA holds.

Eurozone shares fell 0.9% on Friday, but the US S&P 500 rose 0.1% reflecting some stabilisation after several days of falls on North Korean worries. ASX 200 futures fell just 3 points or 0.1% on Friday night, pointing to a broadly flat start to trade Monday after a 1.2% decline on Friday.

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Another "Goldilocks" US jobs report

Monday, August 07, 2017

By Shane Oliver

US and European share markets got a boost on Friday with another “Goldilocks” (not too hot, not too cold) jobs report in the US. As a result, US shares gained 0.2% over the last week and Eurozone shares were up 1.2%. Thanks to gains earlier in the week, Australian shares rose 0.3%, but Japanese shares were flat and Chinese shares lost 0.4%. Global economic and earnings news remains good, but this is partly being offset by the noise around Trump and the risks around US-China trade. Bond yields fell over the week and commodity prices were mixed, with oil down but iron ore up. The $US rose, helped by the solid US July payroll report and this, along with a bit of RBA jawboning, saw the $A fall.  

Trump led US-China trade risk went up another notch. As we noted a few weeks ago, while the risk of a trade war between the US and China went into abeyance during the early part of Trump's Presidency, it’s now on the rise again, partly in response to tensions around North Korea and reflecting a lack of progress in US-China trade negotiations so far. Initially, the focus was on steel, but it looks to be moving on to a review of China's perceived violations of US intellectual property, which has long been a sore point, which could end in tariffs. Our view remains that cool heads will ultimately prevail, but it’s a risk worth keeping an eye on, and one that may escalate if Trump's political woes continue to mount. Even support for Trump amongst his core Republican base is starting to slip a bit, so a ramped up populist “make America great again” campaign around trade could create a useful distraction!

US President, Donald Trump. Source: AAP.

Consistent with its comments over the last few weeks, the RBA has further ramped up its jawboning against the rise in the Australian dollar. It made no significant changes to its growth and inflation forecasts in its latest Statement on Monetary Policy – still seeing a shift to growth a bit above 3%, but with the timing pushed out a bit, and revising its headline CPI inflation forecasts up slightly on the back of rapid utility price increases, but making no changes to its expectation that underlying inflation will be around 2%.

However, it has clearly become concerned that the rising $A poses a threat to both its growth and inflation forecasts. We have been of the view that rates are on hold ahead of a rate hike late next year, but if the Australian dollar continues to trend higher (in contrast to our view for a move lower), it will deliver a further de facto monetary tightening, and further push out the timing of rate hikes (and may even put rate cuts back on the agenda). Of course, continued strength in Sydney and Melbourne property prices would work in the opposite direction, but with the RBA constrained in raising rates to deal with this, the pressure will simply fall back on APRA to deliver another round of measures to further tighten property lending standards.

A couple of things stand out in the latest HILDA report - on household income and labour dynamics in Australia - that has tracked roughly 7000 households since 2001. First, despite all the political noise, income inequality (allowing for taxes and welfare) as measured by the Gini coefficient has changed little since 2001. But, the main driver of the building angst in recent years has been a stagnation in real median household income since 2009 – which, in part, can be traced to record low wages growth. When your own living standard is clearly on the rise as it was for most of last decade, you don’t worry so much about those better off than you, but when you feel like you are stagnating, claims about rising inequality start to resonate.

Second, homeownership rates for 18-39 year olds have fallen by roughly 10 percentage points from 35.7% in 2002 to 25.2% in 2014. Of course, this partly owes to changed demographic trends where we start everything later in life (leaving home, leaving full time study, starting work, getting married, etc) and millennial scepticism about the benefits of home ownership and having a mortgage. But poor and ever-worsening housing affordability is a big factor and must be addressed if we want to avoid rising social tensions – between the “haves” and “have nots” when it comes to owning a patch of the Australian dream. Trouble is that this issue has been brewing since early last decade and it’s only this year that governments have started to really take it seriously.

Major global economic events and implications

US data was solid. Business conditions ISM readings slipped in July but along with the Markit PMIs remain solid, pending home sales rose, payroll employment rose by a stronger-than-expected 209,000 in July and unemployment fell to 4.3%. But inflation pressures remain weak, with wages growth remaining stuck at just 2.5% year on year in July and core inflation in June remaining well below target at 1.5% year on year. The strong US labour market leaves the Fed on track to continue tightening monetary policy, but weak wages growth will keep it gradual.

US June-quarter earnings results remain strong. Of the 420 S&P 500 companies to have reported, 77% have beaten earnings expectations and 68% have beaten on revenue. Earnings look like coming in around 12% yoy, which is almost double the initial expectation.

Eurozone economic growth picked up in the June quarter to 2.1% year on year, its fastest since 2011 and unemployment fell to 9.1% - which is high but down from a high of around 12%. Core inflation rose in July but only to 1.2% yoy.

Chinese business conditions PMIs were mixed in July - down slightly according to the official PMIs but with the Caixin manufacturing PMI up slightly and services PMI down slightly. But the moves are neither here nor there and their levels are consistent with GDP growth remaining around 6.5 to 7%.

Japanese industrial production rose in July and is up 4.9% year on year, with PMIs pointing to reasonable growth ahead.

The Reserve Bank of India cut its official cash rate by 0.25% to 6%, providing a reminder that major central banks are going in different directions with monetary policy. This is consistent with lower inflation. Indian business conditions PMIs also fell sharply in July, although this likely reflects distortions to the July 1 start-up of the goods & services tax. 

Australian economic events and implications

Australian data was a mixed bag. Business conditions PMIs remained solid consistent with other readings of business confidence. Building approvals bounced strongly in June but this was mainly driven by volatile apartment approvals and a fall in new home sales to their lowest since 2013 suggests that the trend will remain down. Retail sales rose more than expected in June and real retail sales rose strongly in the June quarter, providing confidence that GDP growth will bounce back from the softness seen in the March quarter. On the flip side, the trade surplus fell back sharply in June and net exports look to be a flattish contributor to June quarter GDP growth. The Melbourne Institute's Inflation Gauge showed low inflation in July, whereas I would have expected a higher rise in headline inflation on the back of higher electricity prices, suggesting that underlying inflationary pressures remain very weak.

Australian home prices continued to bounce back in July after their soft patch in April and May, particularly in Melbourne. While auction clearance rates and investor lending looks to have slowed, it’s still not clear that the tightening measures announced earlier this year are having a big enough impact so, given the RBA's inability to raise interest rates, further action by APRA may still be necessary.  

Finally, it’s too early to draw any conclusions from the start of the June-half earnings reporting season, as only a few companies have reported. But RIO's result has confirmed a huge upswing in 2016-17 earnings on the back of the bounce in iron ore and other commodity prices and announced a large dividend hike. That said, it came in a little below expectations, so the good news had already been discounted.

What to watch over the next week?

In the US, expect small business optimism to remain solid and job openings to remain strong (both due Tuesday), headline CPI inflation (Friday) to rise to 1.8% year on year in July from 1.6%, but core inflation to remain unchanged at 1.7%. US June quarter earnings results will also continue to flow.

Chinese growth in exports and imports (Tuesday) are expected to remain strong and inflation data for July (Wednesday) is expected to show a dip in CPI inflation to 1.4% year on year and producer price inflation slipping to 5.3% as the earlier surge in commodity prices continues to drop out.

In Australia, Parliamentary testimony by RBA Governor Lowe (Friday) will be watched for further clues on the interest rate outlook, but is unlikely to add much to the just released Statement on Monetary Policy. On the data front, expect the NAB business survey (Tuesday) to show continued solid business conditions and confidence, consumer confidence to remain subdued according to the Westpac consumer confidence survey (Wednesday) and housing finance data (also Wednesday) to show 1% gain for June.

The August profit reporting season will start to ramp up in the week ahead, with around 20 major companies reporting including Cochlear, CBA, AMP, Newscorp and AGL. 2016-17 profits for the market as a whole are likely to have increased by around 18%, driven by a huge 135% gain in resources profits on the back of the rebound in commodity prices. Profit growth for the rest of the market is likely to be around 5.5% led by retailers, utilities, healthcare stocks and financials. As always, in a low interest rate world, dividends will be a key focus, but the key to watch will be on outlook statements as the current financial year won’t have a repeat of the huge boost in commodity prices to resources profits.

Outlook for markets

The risk of a short-term share market correction has increased: the gains in the US share market are increasingly concentrated in a few stocks; political risks in the US have escalated a bit with the Mueller inquiry intensifying and the need to avoid a government shutdown and raise the debt ceiling next month which will likely see the usual brinkmanship ahead of a solution; the risks around US-China trade seem to be increasing; North Korean risks remain; and we are in the weakest months of the year seasonally for shares. While Australian shares have already had a 5% correction from their May high it would nevertheless be vulnerable to any US/global share market pull back. However, with valuations remaining okay – particularly outside of the US, global monetary conditions remaining easy and profits improving on the back of stronger global growth, we would see a pullback as just a correction with the broad rising trend in share markets likely to resume through the December quarter and into 2018.  

Low yields point to ongoing low returns from bonds.  

Unlisted commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this will wane eventually as bond yields trend higher. 

National residential property price gains are expected to slow, as the heat comes out of Sydney and Melbourne. 

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.

The $A has pushed higher on the back of $US weakness, higher commodity prices and technical pressure. While further short term upside is possible, our view remains that the downtrend in the $A from 2011 will ultimately resume as the interest rate differential in favour of Australia is likely to continue to narrow as the Fed hikes rates and the RBA holds. The solid July US jobs report helps take a bit of pressure off the $A and hence the RBA.

Eurozone shares gained 1.1% on Friday as solid US payrolls for July helped depress the Euro, and the solid jobs report also helped push the US S&P 500 up by 0.2%. Following the positive global lead along with a further rise in the iron ore price to $US74.1/tonne ASX 200 futures rose 24 points on Friday night or 0.4% pointing to a positive start to trade for the Australian share market on Monday.

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Is there more upside for the Aussie dollar?

Monday, July 31, 2017

By Shane Oliver

Share markets were soft over the last week. Eurozone shares rose 0.2%, US shares were flat despite good earnings news but Japanese shares fell 0.7%, Chinese shares fell 0.2% and Australian shares lost 0.4%. Bond yields generally rose, but the main development was the continuing softness in the $US, not helped by a dovish interpretation of the Fed and ongoing mayhem around Trump. This, and rising commodity prices, saw the $A briefly rise above $US0.80 for the first time since May 2015.

The rising Australian dollar is not good for the Australian economy. Despite numerous attempts by the RBA to calm down interest rate hike expectations, and lower-than-expected June quarter inflation, the $A continued its ascent over the last week. This, in large part, is a weak $US story, with somewhat dovish comments from the Fed and the political noise (or should I say comedy, given the infighting and revolving team!) around President Trump not helping, but the rebound in commodity prices including a rise in the iron ore price to $US70/tonne is also contributing.

Technical conditions are also playing a role, with the break of the top of the $US0.72-0.78 range that prevailed over the last year or so attracting more buying into the $A. The rise in the $A is a big problem for the Australian economy and is likely contributing to the continuing underperformance of the Australian share market compared to global shares. With mining investment still falling, the consumer under pressure and housing construction looking like it is at or close to peaking, we need a contribution to growth from trade-exposed sectors like tourism, higher education, manufacturing and farming but a rising $A will work against that. Any tourist operator who was thinking of expanding must now be fearing that another run to parity is on the way, which will destroy the flow for foreign tourists and send locals back to Disneyland for their holidays, rather than to North Queensland or Tasmania. What’s more, the strength in the $A will only put more downwards pressure on inflation. All of which makes more RBA attempts to jawbone the $A back down more likely.

In the short term, the $A could still have more upside, but this is not 2007 – don’t expect a return to parity. The $A is overbought, but the breaking of the $A above key points of technical resistance could still attract more foreign buying into it pushing it even higher in the short term. However, this is not March 2007 when the $A burst through $US0.80 on its way towards parity as Australia’s export prices were surging on the back of 10% plus growth in China and a lack of commodity supply, when the Australian economy was growing at 5% year-on-year, underlying inflation was 2.8% and on its way to 5% and the RBA was hiking in response.

Now, the upside in commodity prices is limited by slower growth in China and surging supply, the economy is far from booming, inflation is below target, the RBA is far from tightening and while the Fed may be slower than expected, it is still likely to continue raising rates and start reversing quantitative easing. So, a resumption of the falling interest rate differential between Australia and the US will likely push the $A lower. So, I remain of the view that at some point in the next year the $A will fall back – but trying to get a handle on when that will be, and from what level, is not so easy.

The US soap opera around “reforming” Obamacare had another comeback only to die again. Our view remains that it’s too early to write off Trump's tax reform agenda where there is greater agreement amongst Republicans. The White House and Congressional leaders released a statement highlighting principles for tax reform with a focus on lower tax rates.

US President Donald Trump. Source: AAP.

There was sensible news from the Trump Administration in that current Fed Chair Janet Yellen is reported to be in the running for reappointment as Fed Chair along with Trump’s chief economic adviser Gary Cohn. Yellen’s reappointment would likely cause less financial market volatility, which would probably be in Trump’s interest given the mayhem around him.

While it didn’t attract much attention, the IMF held stable its global growth forecasts for 2017 at 3.5% and 2018 at 3.6% following its latest review. This confirms a break with the last four years where forecasts were continuously revised down.

Major global economic events and implications

In the US, the Fed’s comments around inflation were a bit more dovish and its indication that it will begin allowing its balance sheet to rundown “relatively soon” left a bit of wiggle room as to timing. Our assessment is that with continuing solid US economic data, the Fed is on track to announce the start of allowing its balance sheet to decline in September and will then hike rates again in December. A bout of uncertainty about whether Congress will raise the debt ceiling and continuing low inflation could delay this, but strong economic data is consistent with gradual Fed tightening.

And US data is good, with the past week seeing a rise in the Markit manufacturing conditions index, higher consumer confidence, continuing gains in home prices, a moderate rising trend in capital goods orders, a smaller goods trade deficit, ultra low jobless claims and a bounce back in June quarter GDP growth to a 2.6% pace. Inflationary pressures remain soft though with another soft reading on employment costs.

US June quarter earnings results remain strong. Of the 288 S&P 500 companies to have reported so far, 78% have beaten earnings expectations and 73% have beaten on revenue. Earnings could end up coming in around 12% yoy.

Eurozone economic data was also good. Business conditions PMIs remain strong as do the German IFO and the French INSEE business conditions indexes.

Japan’s manufacturing conditions PMI fell a bit in July but remains solid, small business confidence rose, employment data was strong and household spending was much stronger than expected but core inflation remains stuck at zero.

Australian economic events and implications

Australian inflation remained low in the June quarter with both headline and underlying measures running below the RBA's 2-3% target. While government related prices in areas like utilities, health and education are seeing strong increases, private sector pricing power remains very weak. With growth running below trend, significant spare labour market capacity and now a rising $A bearing down on import prices it’s likely that underlying inflation will remain below target for longer. So, we remain of the view that the cash rate will be on hold for a lengthy period - at least out to late next year. In this regard, a speech by RBA Governor Lowe added to the Deputy Governor a week ago in pushing back against expectations for an early rate hike in Australia. The Governor provided no sense of urgency to raise rates and reiterated that just because foreign central banks raise rates doesn't mean Australia will.

What to watch over the next week?

In the US, the focus will be on the July ISM manufacturing conditions index (Tuesday) which is expected to fall slightly but remain strong at around 56 and payroll employment (Friday) which is likely to show growth of around 180,000 with unemployment falling to 4.3%. Wages growth (also Friday) is likely to remain relatively soft though at around 2.4% year on year and core private consumption deflator inflation (Tuesday) is likely to remain soft at 1.4% yoy. US June quarter earnings results will also continue to flow.

Eurozone core inflation (Monday) for July is likely to have remained weak at around 1.1% yoy keeping the ECB relatively dovish even though June quarter GDP data (Tuesday) is expected to show a pickup in growth to 2.2% yoy.

Japanese industrial production for June (Monday) is expected to show a decent bounce after a fall in May.

Chinese business conditions PMIs to be released starting Monday are expected to show that business conditions remain reasonable consistent with growth remaining around 6.5-7%.

The Reserve Bank of India (Wednesday) is likely to cut rates but the Bank of England (Thursday) is likely to leave policy unchanged.

In Australia, the Reserve Bank (Tuesday) is expected to leave interest rates on hold for the 12th month in a row. While economic growth indicators have improved over the last few months and business confidence and jobs growth is solid, consumer spending remains at risk, housing construction is set to slow, inflation remains below target and is likely to remain so for longer given record low wages growth and the rise in the $A. As a result, the RBA is expected to remain on hold and reasonably neutral with respect to the outlook. The RBA’s latest quarterly Statement on Monetary Policy (Friday) may provide further clues on the outlook for interest rates but we expect rates to remain on hold out to late 2018 at least.

On the data front in Australia, expect credit growth (Monday) to remain moderate, CoreLogic data (Tuesday) to show a (concerning) further rebound in Sydney and Melbourne home price growth in July, building approvals (Wednesday) to have bounced back slightly but in a downtrend, a fall in the June trade surplus (Thursday) & flattish June retail sales (Friday) but a 1.3% gain in June quarter retail volumes.

The August profit reporting season will start in the week ahead with around 15 major companies reporting including Resmed, Rio, Suncorp and Downer. 2016-17 profits for the market as a whole are likely to have increased by around 18%, driven by a huge 135% gain in resources profits on the back of the rebound in commodity prices. Profit growth for the rest of the market is likely to be around 5.5% led by retailers, utilities, healthcare stocks and financials. As always in a low interest rate world dividends will be a key focus.

Outlook for markets

Shares remain vulnerable to a short term setback as we go through the weaker seasonal months out to October with risks around Trump, North Korea, Chinese growth, central banks and the Australian economy all providing potential triggers. However, with valuations remaining okay – particularly outside of the US, global monetary conditions remaining easy & profits improving on the back of stronger global growth, we continue to see the broad 6-12 month trend in shares remaining up.

Low yields point to continuing low returns from sovereign bonds

Unlisted commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this will wane eventually as bond yields trend higher.

National residential property price gains are expected to slow, as the heat comes out of Sydney and Melbourne.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.

The $A has pushed higher on the back of $US weakness, higher commodity prices and technical pressure. While further short term upside is possible, our view remains that the downtrend in the $A from 2011 will ultimately resume as the interest rate differential in favour of Australia is likely to continue to narrow (as the Fed hikes rates and the RBA holds).

Eurozone shares fell 0.8% on Friday, but the US S&P 500 was flat. ASX 200 futures rose 24 points on Friday night, or 0.4%, pointing to a partial retracement of Friday’s 1.4% fall in the ASX 200 when the Australian share market opens on Monday.

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Is it too early to write off Trump's tax reform agenda?

Monday, July 24, 2017

By Shane Oliver

Share markets were mixed over the last week, with US shares up 0.5% helped by good earnings news and Chinese shares up 0.7%, but Japanese down 0.1%, Eurozone shares down 2% on the back of a rising Euro, and Australian shares down 0.7% on the back of perceptions that the RBA has become more hawkish. Bond yields fell. Oil prices fell but metals and iron ore rose, helped by further falls in the $US. This, along with perceptions of a more hawkish RBA, helped push the $A towards $US0.80 although this was dampened a bit by somewhat dovish comments by RBA Deputy Governor, Guy Debelle.  

It's still too early to write off Trump's tax reform agenda. The failure of US Senate Republicans to agree on either a "repeal and replace" or "repeal and delay" of Obamacare obviously adds to uncertainty around whether Republicans in Congress can agree amongst themselves on a budget, government funding to avoid a shutdown in September, an increase in the debt ceiling (which is necessary by early October) and most importantly, on tax reform. Of course, health care reform could make yet another comeback, but uncertainty around all of these could cause bouts of angst in investment markets in the next few months.

However, as we saw in 2013, it’s in neither of the major party's interest to allow a US government shutdown and neither party wants a debt default. More importantly though, while the risks around tax reform have increased, Republicans are in general agreement on wanting lower taxes, they need a win prior to next year's mid-term elections and after the mid-terms, it’s unlikely they will be able to cut taxes because the Democrats are likely to have won control of at least the House of Representatives. So, we still lean towards some sort of tax reform getting up. Interestingly though, financial markets appear to have largely given up on it, but it hasn't stopped the US share market pushing new record highs.

US President Donald Trump. Source: AAP.

The reported widening of special counsel Robert Mueller’s investigation to include President Trump’s business dealings adds to the risks around Trump, but we remain of the view that in the absence of clear evidence of criminal activity, his own party won’t seek to impeach him, but after next year’s mid-terms the Democrats probably will, so it all just adds to the case for Republicans to get their business-friendly reforms down now while they can.

Noise around a US trade war with Mexico and China is likely to pick up, with the renegotiation of NAFTA coming up and signs of some deterioration in relations between the US and China and little progress in their Comprehensive Economic Dialogue. Time will tell, but the US' objectives for the NAFTA renegotiation suggest limited changes, US-China trade talks are continuing and we remain confident that despite lots of noise and partial moves (eg, US tariffs on steel imports) that cool heads will ultimately prevail.

Not another attempt to come the raw prawn with us on Australian interest rates! The financial market reaction to the minutes from the last RBA meeting was way over the top. Don't read too much into them. I must admit to finding the periodic discordance between the post meeting statement and the minutes a bit disturbing - surely they relate to the same meeting and so should leave the same impression. It does make me wonder though whether the high level of RBA communications could just be adding to noise and confusion around interest rates at times. Mind you, this is a much bigger problem in the US. 

But back to where interest rates are headed ... the minutes certainly did sound a bit more upbeat than the initial post-meeting statement about growth and wages. But the bit that caused most excitement was the reference to a 3.5% neutral rate of interest, i.e., the rate of interest consistent with growth at potential, inflation at target and which neither causes the economy to accelerate or decelerate. Some have interpreted this as indicating that a series of eight quarterly rate hikes of 0.25% are imminent. This is very doubtful.

First, the neutral rate discussion looks to have been just a regular “deep dive” into a key issue and so, as Deputy Governor Guy Debelle pointed out, “no significance should be read into the fact the neutral rate was discussed” at the last meeting. 

Guy Debelle, Deputy Governor of the Reserve Bank of Australia. Source: AAP.

Second, the neutral rate is a rubbery rather academic concept, a bit like the non-inflation accelerating rate of unemployment (NAIRU) and the “output gap”. In theory, it should be around long run potential nominal growth, but it can move around a lot given attitudes to debt and debt levels, the gap between the rates bank lend at and the official cash rate, inflation expectations, uncertainty about what potential growth is, etc. At the Fed, they refer to a long-term neutral rate (seen to be around 3% at present) and a short-term neutral rate, with Fed Chair Yellen recently saying it was already close to neutral with the Fed Funds rate at just 1-1.25%! So, while a comparison to some neutral rate may be of use in assessing whether policy is easy or tight, it’s not a firm target that central banks head for.

Third, for what it’s worth our assessment is that because of higher household debt to income levels and higher bank lending rate spreads, the neutral rate is around 2.75%.

Fourth, a rise in the cash rate to 3.5% over the next two years, if passed on in full, would push the ratio of household interest payments to household disposable income from 8.6% currently, to around 12%. This would be well above the average ratio of 9.6% since 2000, above the 2011 peak of 11.4% and towards the pre GFC peak of 13.2%, both of which saw hits to consumer spending – see the next chart. The hit this time would likely be greater as unlike a decade ago households lack the optimism to take on more debt to cover higher interest payments (remember the ATM in the lounge room!). So the 3.5% of income hit to spending power would likely take a big chunk out of consumer spending. Of course these numbers are averages - for those households with a mortgage the interest payment to income ratio would be around three times higher and in Sydney and Melbourne it would be even higher again. Which all suggests that in the absence of much stronger economic conditions rates won’t be increased by 2%.

Source: RBA, AMP Capital

Finally, heightened rate hike expectations have already pushed the $A above $US0.79 and a cash rate of 3.5% would likely see it soar, exacting another round of damage on the economy just at a time when we still need a lower currency to offset the impact of still falling mining investment.

Reflecting all these influences, when it does come time to start raising rates the RBA won't be on autopilot on its way up to 3.5% but rather will be incremental, i.e., hike 0.25% and then wait to assess the impact. And, as we have seen with the Fed, the process is likely to be very gradual and we doubt that rates will be able to go as high as 3.5% any time soon as the RBA won't want to crash the economy. As to the timing of the first rate hike, while the RBA's upbeat view suggests the risk of an earlier move, our view remains that it won’t occur until late next year. While jobs growth and business confidence are good, other indicators are far more mixed - particularly around the consumer, wages and underlying inflation.

It’s worth noting that Deputy Governor Debelle also pointed out that: rate hikes by other central banks do not mean that the RBA has to raise rates too; interest rates in both the US and Canada remain below those in Australia; a rising $A works against the benefit of stronger global growth; and that a lower $A “would be helpful”. It’s hard to see any sign of an imminent RBA rate hike in any of this.

Major global economic events and implications

It was a bit of a quite week on the data front in the US, but housing data was okay with home builders’ conditions still strong and housing starts bouncing back and jobless claims remaining low. New York and Philadelphia regional manufacturing conditions surveys fell but remain strong. Meanwhile, it's early days, with only 96 S&P 500 companies reporting so far, but the June quarter earnings reporting season is off to a strong start, with 81% exceeding earnings and 77% beating revenue expectations. Earnings are likely to have increased 10% over the year to the June quarter.

As expected, the ECB made no changes to monetary policy sounding more upbeat on growth but “not there yet” in terms of seeing inflation heading back to target. It still looks on track to announce a cutback later this year in its quantitative easing program to around €30bn a month for 2018 (from €60bn a month this year). I doubt this warrants recent Euro strength though and if the Euro continues to rise it’s likely that the ECB will start to worry about its impact on growth and back off again. Meanwhile, the ECB's June quarter bank lending survey showed an ongoing improvement in the availability of credit and demand for it.

Again as expected, the Bank of Japan made no changes to monetary having committed to continue quantitative easing and targeting a zero 10-year bond yield until inflation - which is currently around zero - reaches above 2% which it doesn't now expect until 2019. The BoJ will remain a big laggard when it comes to monetary tightening resulting in a falling Yen.

Chinese data was solid across the board - with June quarter GDP growth holding at 6.9% year on year and industrial production and retail sales picking up. With growth stronger than expected, there is a rising chance that the People's Bank of China will soon raise official interest rates. Don't expect an aggressive tightening though as inflation remains benign.

Australian economic events and implications

Australian jobs data came in on the strong side again in June, with full-time jobs again driving growth reversing the weakness seen up until a few months ago. If sustained, this should help cut into underemployment - but it's not clear that it's enough to drive stronger wages growth. Meanwhile, APRA's long-awaited determination that Australia's big banks will need Tier 1 capital ratios of at least 10.5% by 2020 to be "unquestionably strong" saw banks rally sharply as it was less onerous than feared and removes one source of uncertainty for the banks.

What to watch over the next week?

In the US, the focus will be on the Federal Reserve’s meeting on Wednesday, but given recent softness in inflation readings and in some data releases, it’s not likely to make any changes to monetary policy. However, it may flag again that an announcement to start letting its balance sheet run down will be made soon. We expect this to occur at its September meeting and continue to expect the next rate hike to come in December, albeit there is a risk that if inflation does not soon pick up it could be delayed into 2018. On the data front, June quarter GDP data (Friday) will be watched for a rebound after the seasonally weak March quarter. However, growth is only likely to have bounced back to around 2.5% annualised. Meanwhile, expect July business conditions PMIs to remain reasonably solid (Monday), home prices to show further gains but consumer confidence to fall slightly albeit from very high levels (both Tuesday) and decent gains in durable goods orders (Thursday). June quarter employment cost data (Friday) is expected to show that wages growth remains moderate. The US earnings reporting season will also ramp up with over 100 S&P 500 companies reporting

Eurozone business conditions PMIs will also be released Monday and economic confidence data will be released Friday and both are likely to remain strong.

Expect Japanese data to be released Friday to show continued labour market strength, some improvement in household spending but core inflation remaining around zero.

In Australia, June quarter inflation data and a speech by RBA Governor Lowe, both on Wednesday, will be watched for clues on the interest rate outlook. In terms of inflation, we expect consumer prices to have risen by 0.6% quarter on quarter or 2.4% year on year in the June quarter with a fall in petrol prices only partly offsetting higher vegetable prices on the back of Cyclone Debbie, an increase in tobacco excise and seasonal increases in prices for clothing and furnishings. Underlying inflation though is likely to be constrained by weak wages growth and come in at around 0.5% quarter on quarter and 1.8% year on year. As this is in line with RBA expectations, it's unlikely to alter the outlook for monetary policy. Governor Lowe's speech may provide more insight on this front, and will be watched closely to see whether he reinforces the more hawkish impression given by the recently released minutes, or seeks to lean against them as Deputy Governor Debelle has done.

Outlook for markets

Shares remain vulnerable to a short-term setback as we go through the weaker seasonal months out to October with risks around Trump, North Korea, Chinese growth, the Fed and the Australian economy all providing potential triggers. However, with valuations remaining okay – particularly outside of the US, global monetary conditions remaining easy and profits improving on the back of stronger global growth, we continue to see the broad 6-12 month trend in shares remaining up. 

Low yields point to low returns from sovereign bonds.  

Unlisted commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this will wane eventually as bond yields trend higher. 

National residential property price gains are expected to slow, as the heat comes out of Sydney and Melbourne. 

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.

The $A has recently pushed higher helped by a combination of a generalised fall in the $US, some better Australian economic data and more upbeat comments from the RBA. And the break of previous resistance around $US0.78 could see it push above $US0.80 in the short term. However, our view remains that the downtrend in the $A from 2011 will ultimately resume as the interest rate differential in favour of Australia is likely to continue to narrow and will likely reach zero early next year (as the Fed hikes rates and the RBA holds) and commodity prices will also act as a drag.

Eurozone shares fell 1.3% on Friday not helped by a further rise in the Euro, but the US S&P 500 fell less than 0.1%. ASX 200 futures lost 25 points or 0.4% on Friday night pointing to a soft start to trade at the open for the Australian share market on Monday.

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US shares helped by another "Goldilocks" jobs report

Monday, July 10, 2017

Investment markets and key developments over the past week

Global share markets were volatile again over the last week as bond yields backed up, further continuing the latest “taper tantrum” that was kicked off by several central banks led by the ECB just over a week ago. However, news of solid jobs growth helped US shares gain on Friday resulting in a weekly rise of 0.1%. Eurozone shares rose 0.5% for the week, but Japanese shares lost 0.5% and Chinese and Australian shares fell 0.3%. Bond yields continued to rise partly in response to the minutes from the last ECB meeting which indicated it considered dropping its easing bias (but decided against it because it might trigger a tightening in financial conditions - which of course has happened anyway!). Commodity prices slipped and this combined with a still neutral RBA contributed to a fall back in the $A, which is continuing to bounce up and down in the same $US0.72-78 range it’s been in for more than a year now.

The back up in bond yields in response to a shift to a somewhat more hawkish tone from several central banks could have further to run, but for shares its likely just another correction. After strong gains and signs of investor complacency shares and bonds have been vulnerable to a correction for some time. The first “taper tantrum” in 2013 which was kicked off by then Fed Chair Ben Bernanke’s comments around slowing or tapering the Fed’s quantitative easing program saw share markets fall 6-11% and 10-year bond yields in the US and Australia rise by around 140 basis points. However, we remain of the view that the latest taper tantrum will settle down. The only reason central banks have become a bit more hawkish is because global growth has improved which in turn is good for profits and shares, monetary tightening by the ECB and other central banks even when it does get underway will be very gradual (with the recent back up in bond yields and the Euro likely to further slow the ECB) and it will be a long time before global monetary policy is tight and hence threatening to shares. So expect the correction in shares to remain just that and the uptrend in bond yields to remain gradual (despite occasional spurts higher).

Of course, in Australia the RBA has not even joined the hawkish tilt of other global central banks. In fact, after its July meeting the RBA retained a neutral bias in terms of the outlook for monetary policy. Not following other central banks with a hawkish tilt was a good move because not only would it have been premature and unnecessarily scare the horse as one Board member put it, but the failure to do so helped knock the $A a bit lower. Our view remains that the RBA will be on hold for the next year at least, with risks around the consumer and a housing slowdown preventing hikes but a fading in the drag from the mining investment slump and solid employment growth heading off cuts. A recent good run of data in Australia – for jobs, retail sales and trade – has seen the risk of another rate cut in the short term recede.

·         North Korea is back in the headlines as a threat to the world and as a source of investment risk following the testing of an Intercontinental Ballistic Missile which looks to have been designed to achieve maximum annoyance ahead of the July 4 Independence Day holiday in the US. North Korea’s progress towards being able to reach the US with nuclear weapons is clearly continuing. This led to the usual condemnation from western countries and talk of sanctions. But it’s a tough one: a military strike against North Korea is obviously being considered again but the likely catastrophic consequences for Seoul/South Korea and potentially Japan mean that some form of diplomatic solution to contain the threat is more sensible and hopefully more likely. North Korea could be a source of further volatility in share markets, but trying to protect investment portfolios against the threat it poses (beyond buying defence stocks and safe havens like government bonds, cash and gold) is a bit like trying to hedge against the risk of nuclear war in the post war era.

New Zealand is showing Australia up. Not only do they have a sensible energy policy and climate change strategy, a sensible tax system, budget surpluses, falling public debt and faster broadband all achieved with a fraction of the angst Australia seems to go through…but they have just won the America’s Cup! Which is something we were did once when we were about to embark on a roughly twenty year run of economic reforms. Sporting achievements aside, our populist Senate and bouts of ideological and/or personality driven politics in our major political parties is working against our national interest.

Major global economic events and implications

US data was solid. The ISM manufacturing and services conditions indexes rose to strong readings above 57 and while the Markit PMIs are a bit softer, overall it suggests that US businesses are doing well. Payroll employment was strong in June and even though unemployment rose slightly this was due to higher labour force participation. And core capital goods orders were also revised up to show a small rise in May. Against this construction data for May was soft and wages growth continued to remain subdued at just 2.5% over the 12 months to June. The minutes from the last Fed meeting added little that was new with debate over when to start letting the Fed’s balance sheet run down (ie reversing quantitative easing) and the case for letting the labour market run a little hot against the risks regarding financial stability of leaving interest rates too low for too long. Overall, we are inclined to see the Fed announce the start of the balance sheet run-off in September and then wait to December given recent soft inflation data before raising rates again. The “Goldilocks” June jobs report with solid jobs growth but weak wages growth keeps the Fed on track to tighten but only gradually.

Eurozone manufacturing and services conditions PMIs for June were revised up to solid levels consistent with solid growth. While strong growth indicators point to the ECB reducing its quantitative easing program for next year (from €60bn a month to €30bn a month) the back up in bond yields and the Euro, low inflation and risks around Italy suggest that this is unlikely to be announced until late this year and that the first rate hike won’t occur until late next year.

Japan’s Tankan business conditions survey improved a bit more than expected and points to ongoing reasonable economic growth.

Chinese business conditions PMIs mostly rose in June consistent with a stabilisation or modest improvement in growth after a modest slowing.

Australian economic events and implications

Australian data was mostly on the strong side. The Australian Industry Group's business conditions PMIs were solid in June, retail sales rose nicely for the second month in a row in May pointing to solid consumer spending in the June quarter, the ANZ job ads survey remained strong pointing to solid jobs growth and the trade surplus rebounded in May as coal exports recovered after the impact of Cyclone Debbie and gas exports rose strongly as LNG projects complete. However, it would be wrong to break out the champagne just yet as building approvals fell sharply in May confirming that home building activity is set to slow and low wages, high underemployment and the July surge in power prices will weigh on consumer spending going forward. In other data, home prices bounced back in June after seasonal weakness in May but momentum in Sydney and Melbourne is continuing to slow and the Melbourne Institute's Inflation Gauge showed continuing benign inflation.

What to watch over the next week?

G20 summits usually don’t have much financial market impact in times of reasonable economic conditions, but there is perhaps a bit more uncertainty around the July 7-8 Summit given the potential for President Trump to throw curve balls (eg, around China and North Korea) and his stance on trade.

In the US, expect continued strength in small business confidence and job openings (Tuesday), retail sales and industrial production to show solid growth and core consumer price inflation (all due Friday) to remain around 1.7% year on year. Fed Chair Yellen’s Congressional Testimony (Wednesday and Thursday) will be watched for clues on the outlook for US monetary policy. The Fed’s Beige Book of anecdotal evidence on the economy is likely to remain stuck in “modest to moderate” mode in terms of the characterisation of the US economy. US June quarter earnings will start to flow with the analyst consensus looking for a 7.4% year on year rise in earnings but the final outcome likely to be around +10%.

Chinese June inflation data (Monday) is expected to show CPI inflation stuck at 1.5% year on year and producer price inflation unchanged at 5.5% yoy after recent falls.  June trade data (Friday) is expected to show import growth at 15% yoy and export growth rising slightly to 10% yoy.

In Australia, expect housing finance (Tuesday) to have risen after 3 months of falls, business confidence and conditions to remain reasonably solid in the June NAB business survey (also Tuesday) and consumer confidence (Wednesday) to have remained a bit below average in July.

Outlook for markets

Shares are vulnerable to a further short term setback as we go through the seasonally weak September quarter with the back up in bond yields on central bank exit talk looking like it has further go and risks remaining around Trump and North Korea. However, valuations remain mostly okay – particularly outside of the US, global monetary conditions are set to remain easy and profits are improving on the back of stronger global growth, so we continue to see the broad 6-12 month trend in shares remaining up. Australian shares are likely to end the year higher but will likely remain relative underperformers compared to global shares.

Low yields and a gradual uptrend in them point to low returns from sovereign bonds.

Unlisted commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this will wane eventually as bond yields trend higher.

National residential property price gains are expected to slow, as the heat comes out of Sydney and Melbourne. Perth and Darwin are near the bottom and other capitals are likely to see moderate growth.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.

Our view remains that the downtrend in the $A from 2011 will resume this year. The rebound in the $A from the low early last year of near $0.68 has lacked upside momentum, the interest rate differential in favour of Australia is continuing to narrow and will likely reach zero early next year (as the Fed hikes rates and the RBA holds). Expect a fall below $US0.70 by year end.=

Eurozone shares were flat on Friday but the US S&P 500 rose 0.6% helped by more “Goldilocks” jobs data for June (with payrolls up solidly but low wages growth implying little upwards pressure on inflation). Reflecting the positive US lead and a rise in the iron ore price ASX 200 futures rose 10 points or 0.2% pointing to a modest positive start to trade for the Australian shares market on Monday.

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Taper tantrum 2.0

Monday, July 03, 2017

By Shane Oliver

Investment markets and key developments over the past week

Global share markets had a rough ride over the last week as somewhat more hawkish comments from central banks weighed and pushed bond yields higher. This was particularly the case in Europe with Eurozone shares down 2.6% for the week, against falls of just 0.6% in the US and 0.5% in Japan. Chinese shares actually rose 1.2%. Meanwhile, commodity prices rose solidly from oversold and under loved levels - particularly oil (up 7%) and iron ore (up 14%). Reflecting higher commodity prices and a weaker $US, the $A bounced back to around $US0.77 although it’s worth noting that it’s been stuck between $US0.72 and $US0.78 for more than a year now. Despite the weakness in US and European shares, Australian shares managed a 0.1% over thtae last week helped by a rebound in commodity prices and inflows into super funds ahead of limits affecting some members starting July. July is normally a strong month for Australian shares although the pull forward of super flows into June could be a drag this July.

Source: Bloomberg, AMP Capital

Taper tantrum 2.0 - some more hawkish noises from central banks, but don't get too excited. Central bankers from the Fed, the ECB, the Bank of England and the Bank of Canada all sounded a bit more hawkish over the last week, with the last three signalling an eventual end to ultra easy monetary policy. But there are several points to note in relation to this:

First, the shift in the tone of central bank commentary - notably at the ECB, Bank of Canada and Bank of England - in large part just matches the improvement seen in growth and the receding risks of deflation so should be seen as good news. But with underlying inflationary pressures remaining weak, global monetary policy remains a long way from anything approaching being tight and this is likely to remain the case for some time.

Second, Fed Chair Yellen is just reiterating her long stated comments that it’s appropriate for the Fed to gradually remove monetary accommodation providing the US economy continues to improve. However, while she does not appear to be too concerned about inflation running below target because the labour market is so tight, others at the Fed have expressed concern about the inflation undershoot and so there is now a high chance that the Fed will skip a September rate hike and wait until December before moving again. There is nothing in what Yellen has said pointing to a faster tightening.

Third, while several Fed officials (Yellen, Fischer and Williams) referred to strength in the US share market/asset prices its noteworthy that Yellen referred to the ongoing debate about shares looking a bit expensive on absolute measures (like PE's) but maybe not so on a relative basis (if low bond yields are allowed for). What does seem clear though is that at the current point the Fed does not see the share market as a constraint on raising rates. Obviously if it has a sharp fall on the back of growth worries this would be different.

Fourth, ECB President Draghi is clearly (and rightly) becoming more upbeat with the threat of deflation receding and "political winds...becoming tailwinds" (presumably a reference to President Macron's pro-reform and pro-Europe election victory in France in particular). And why wouldn't he with Eurozone economic confidence at its highest in nearly a decade.

As such he is right to warn policy will need to adjust once inflation rises. But at this stage there is still little evidence of much of a tick up in underlying inflation and political risk around Italy will likely slow Draghi from moving too quickly. Our view remains that the ECB will announce a 2018 taper to its quantitative easing program later this year but that rate hikes are a while away. And the Bank of Japan remains years away from any easy money exit.

More broadly we have been concerned for some time that global shares are vulnerable to a correction. As we have seen over the last week, worries about central bank tightening have provided a potential trigger. But as we have seen with the Fed since it first started the process of monetary tightening with taper talk four years ago, monetary tightening is likely to remain very gradual and conditional on further economic improvement. A share market correction yes - just like we saw with the 2013 taper tantrum -  but we are a long way from the sort of tight monetary policy that could bring the bull market in shares to an end.

The rally in bonds this year had arguably gone a bit too far - things weren't that bad - and positioning had become excessively long and complacent leaving them vulnerable to a rebound in yield that we are now seeing. However, with inflationary pressures remaining weak and monetary tightening likely to remain gradual (and non-existent in many countries including Australia for some time) the uptrend in bond yields is likely to remain gradual too.

Delay in the US Senate vote on healthcare reform by a week or two is unlikely to be fatal. The delay looks to be more about allowing time for Republican Senators to discuss changes to the bill. Recall that healthcare reform was also thought dead in the House earlier this year when a vote on it was cancelled - only to see it pass a month or so later. Since Republicans and President Trump agree on reforming Obamacare and tax reform (tax cuts) our view remains that it will be passed clearing the way for the latter.

Eight rate hikes over the next two years from the RBA? Don't come the raw prawn with me...in other words I doubt it. Former RBA board member John Edwards comment that if the RBA forecasts - for growth to pick up above 3% and inflation to be around 2.5% by mid-2019 - come to fruition then the RBA "will want the cash rate to be 3.5% at least by end 2019" coming on the back of more talk of monetary tightening globally over the last week have naturally sparked a bit of interest. However, it’s doubtful this will happen. First, even if the RBA forecasts are correct it’s likely that the rise in household debt ratios means the neutral rate of interest (appropriate for an environment of 3% growth and 2.5% inflation) has fallen to maybe 2.5-3%. A 2% rise in mortgage rates on top of the rate hikes for investors and interest only borrowers already announced would mean a 50% plus rise in interest servicing costs relative to household income from late last year and likely cause a significant slowing in consumer spending and risk a rapid decline in home prices in Sydney and Melbourne. And the RBA knows this (and so won't be that extreme). Second, the RBA only forecasts underlying inflation around 2%, ie the low end of its target range, out to the end of 2018, making it hard to justify much in the way of rate hikes for the next 18 months. Third, eight rate hikes would likely push the $A higher damaging our competitiveness and services exports like tourism and higher education when we still need to see strong growth in them. Finally, the risks to the RBA's growth and inflation forecasts are likely on the downside. Our view remains that rates are on hold ahead of a rate hike maybe in 2019.

Major global economic events and implications

US data was mostly good over the last week. Durable goods orders and new home sales were softish, but consumer confidence saw an unexpected rise (to around its highest since the early 2000), home prices continue to rise, inventory levels rose more than expected in May, unemployment claims remain ultra low and March quarter GDP growth was revised up slightly to 1.4% annualised due to a stronger consumer. May data showed that consumer spending looks to be on track for a solid June quarter gain, but the rate of inflation as measured by the core personal consumption deflator dipped to just 1.4% year on year which will help keep the Fed gradual.

Meanwhile, major banks in the US were cleared by the Fed to pay out hefty dividends and undertake buybacks following recent stress tests indicating capital levels at banks are healthy. The post GFC US bank capital rebuild is now complete and the tide is turning against heavy handed regulation of them.

In Europe, economic confidence rose to its highest in a decade driven by both consumer and business confidence pointing to stronger economic growth. Similarly, the German IFO business conditions index was stronger than expected reaching a post-reunification high. Meanwhile, core inflation edged up in June but only to 1.1% year on year.

Japanese data for May showed strong jobs vacancies to applicant’s data (aided by a falling population), strong growth in industrial production on an annual basis and less negative household spending but core inflation still stuck around zero. With core inflation well below the Bank of Japan's 2% target, no change to BoJ ultra easy money is in sight.

China's official business conditions PMIs surprisingly improved in June, suggesting that the recent slowing in growth may have come to an end. In fact, I just got back from China and it looks as frantic as ever.

Australian economic events and implications

Australian data was light on with only second order releases. Credit growth remains moderate with weak personal and business lending and some moderation in property investor lending as recent APRA measures hit. Continued solid growth in jobs vacancies over the three months to May according to ABS data adds to confidence that employment growth will remain solid in the months ahead. Meanwhile, population growth picked up to 1.6% in 2016 from 1.4% in 2015 confirming that underlying demand for housing remains strong and helping underpin potential growth in the economy. About 60% of the increase was due to net immigration and Victoria remained the fastest growing state with a 2.4% population gain in 2016. WA and NT were near the weakest.

What to watch over the next week

In the US the focus will be on the ISM manufacturing conditions index to be released Monday and jobs data to be released Friday. Expect the manufacturing conditions index to remain solid at around 55 and jobs data to show solid payroll growth of 175,000 and unemployment remaining very low at 4.3% but wages growth still subdued at around 2.6% year on year, all of which will be enough to keep the Fed on track for gradual rate hikes. In other data, expect the ISM non-manufacturing conditions index (Thursday) to have remained solid at around 56 and the trade deficit (also Thursday) to improve slightly. The minutes from the Fed’s last meeting (Wednesday) will also be looked at for clues on the outlook for interest rates.

Expect the Eurozone unemployment rate for May to be released Monday to show a fall to 9.2%.

In Japan the Tankan business survey for the June quarter (Monday) is expected to show improved conditions.

China’s Caixin manufacturing PMI will be released Monday.

In Australia, the Reserve Bank is expected to leave interest rates on hold for the 11th month in a row. While we see downside risks to the RBA’s growth and inflation forecasts, the RBA has recently indicated a preparedness to look through recent volatility in GDP data, remains optimistic that growth will pick up to around 3% and likely lacks confidence that the Sydney and Melbourne property markets have cooled enough just yet. While at some point the RBA may talk about exiting easy money - causing a bit of premature excitement in the process, our base case remains that the RBA will leave interest rates on hold for the next year at least, but for the next year there remains more risk of a cut than a hike.

On the data front in Australia, expect CoreLogic data for June to show a bounce in home prices (Monday) after seasonal weakness seen in May but to confirm softer conditions overall and building approvals for May (also Monday) to show a decline, retail sales to rise 0.2% (Tuesday) and the May trade surplus (Thursday) to bounce back as coal exports recover. The AIG’s business conditions PMIs and ANZ job ads will also be released.

Outlook for markets

Shares are still vulnerable to a short term setback as we are go through a weaker seasonal period for shares with risks around the Fed and central bank exit talk, Trump, North Korea, Chinese growth and the Australian economy all providing potential triggers. However, valuations remain okay – particularly outside of the US, global monetary conditions remain easy & profits are improving on the back of stronger global growth, so we continue to see the broad 6-12 month trend in shares remaining up.

Low yields point to low returns from sovereign bonds. Expect a resumption of a gradual uptrend in yields. 

Unlisted commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this will wane eventually as bond yields trend higher.

National residential property price gains are expected to slow, as the heat comes out of Sydney and Melbourne.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.

Our view remains that the downtrend in the $A from 2011 will resume this year. The rebound in the $A from the low early last year of near $0.68 has lacked upside momentum, the interest rate differential in favour of Australia is continuing to narrow and will likely reach zero early next year (as the Fed hikes rates and the RBA holds or cuts). Expect a fall below $US0.70 by year end.

Eurozone shares fell 0.5% on Friday, but the US S&P 500 gained 0.2%. Reflecting the positive US lead and gains in oil and iron ore prices ASX 200 futures rose 21 points or 0.4% pointing to a positive start to trade for the Australian share market on Monday.

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Lower oil prices a bonus for consumers

Monday, June 26, 2017

By Shane Oliver

Global shares mostly rose over the last week, despite falls in energy shares, as economic data was mostly good and there was good news for Trump’s pro-growth agenda in the US. US shares rose 0.2%, Japanese shares rose 1%, Chinese shares rose 3% but Eurozone shares lost 0.3%. Australian shares fell 1%, thanks to a combination of falling oil prices hitting resource stocks, "fear of Amazon" weighing again on retailers and worries (mistaken in my view, given it will take so long) that China's inclusion in MSCI share benchmarks will see funds flow out of Australian shares. Bond yields were flat to down, the plunge in the oil price continued, and this, along with a slightly stronger $US, weighed on the $A.

Oil price plunges, inflation still MIA, interest rates to remain low - good news for Australian consumers

The oil price has been trending down since February amid concerns that rising non-OPEC production will offset OPEC production cuts. This hit the headlines over the last week, as the decline pushed beyond 20%. While oil is oversold and sentiment towards oil is so negative it's pointing to a bounce, it’s hard to get excited. Particularly with steadily rising shale production in the US putting a cap on price upside. 

More broadly, the weak oil price highlights the broader lack of inflationary pressure globally, which will keep interest rates low. However, low oil prices mean low petrol prices and this is positive for consumers. In Australia, if current oil prices are sustained, the retail price of petrol could fall towards $1.10 a litre. This implies a saving for the average family’s weekly petrol bill of around $6 compared to January. 

Source: Bloomberg, AMP Capital

Which is good news, given the self-inflicted wound flowing from higher electricity prices in Australia. And if oil prices stay low, or fall further, it will mean lower gas export prices which could take pressure off the domestic gas market. One can only hope!

Chinese A shares in MSCI's share benchmarks 

The inclusion of Chinese mainland (or A) shares in MSCI's share benchmarks is another sign of the opening up of the Chinese share market and its integration globally, but it has a long way to go. The inclusion only relates to large-cap shares accessible by foreigners via the Hong Kong share connection. Initially, the weight of Chinese shares in the MSCI emerging market index will be just 0.7%, whereas right now, the Chinese share market is 9% of total global share market capitalisation and it won't start phasing in till May next year.

Full inclusion may take 5-10 years. And the initial index-related flows into the Chinese share market flowing from the move are likely to be less than half typical daily turnover in the Chinese share market. So, don't expected a huge short-term impact. However, the impact on Chinese shares will grow over time, as the exposure in the MSCI indexes is likely to rise. And it’s another sign that China is now becoming an integral part of the global financial system. Over time, the increasing participation of foreign institutional investors will help enhance the rights of Chinese shareholders and add to the liquidity and reduce the speculative tendencies in the Chinese share market.

Major global economic events and implications

While the noise around President Trump continues to swirl, the past week confirmed that his policy agenda remains on track, with the Senate having released its draft Obamacare reform bill and close to a vote on it; Treasury Secretary Mnuchin and House Speaker Ryan confirming tax reform remains a top priority; a draft executive order on the health industry focussing on easing regulations and Republican election victories providing impetus to Trump's agenda.

US President Donald Trump. Source: AAP

On the data front, home sales, home prices and the leading index rose and jobless claims remain ultra weak but the Markit business conditions PMIs fell slightly in June, despite strong new orders. Major US banks also passed the first stage of the Fed’s latest bank stress tests, as would be expected in this environment.

Eurozone consumer confidence rose to its highest in 16 months and French business confidence rose to a 6-year high. Against this, the composite business conditions PMI fell slightly in June, albeit it remains strong.

Australian economic events and implications

ABS home price data confirmed continued strength in the March quarter, but a lot has happened since then, with bank rate hikes for investors and interest only borrowers, tighter lending standards and evidence the Sydney and Melbourne property markets have started to cool. Skilled vacancies remained strong in May, pointing to continued solid jobs growth for now. 

More bank mortgage rate hikes, but cuts for owner occupiers paying principle and interest. The drip feed of bank rate hikes has continued, but it’s worth putting this in perspective. Reflecting regulatory pressure and banks managing their risks, the rate hikes have been for investors, and more recently, for interest only (IO) borrowers. See the chart below. In the last week, banks have been cutting their variable rates for owner occupiers on principle and interest (P&I) loans. (Note: the chart below relates to standard variable rates, discounted rate are around 0.75% lower.)

While the hike in investor and interest-only rates (of around 0.3% for investor P&I loans, 0.75% for investor IO loans and 0.5% for owner occupier IO loans since November) are a dampener, they are modest compared to past rate-hiking cycles, investors can get up to half of it back from the tax man and nearly 80% of owner occupiers are on principle and interest loans and many of them have seen a small a rate cut over the last week.

The main uncertainty relates to the impact on interest-only owner occupiers – but, of course, if there is a problem there in terms of repayments as they move across to P&I that threatens overall economic growth, the RBA can simply offset the increase in mortgage costs by cutting the cash rate again (and yes – for owner occupiers, it’s likely the banks would pass it on).   

Source: RBA, AMP Capital

News that South Australia will add to the Federal Government’s bank levy adds to concerns that a Pandora’s box has been opened in Australia on the tax front. It’s understandable that businesses will fear that if they are in an industry that does well and is unpopular, they will be hit with a higher tax rate. Good tax policy seeks to minimise distortions with a single tax rate across all industries and we seem to be moving away from that. 

What to watch over the next week?

US data to be released in the week ahead will provide an update on business investment, consumer confidence and the Fed's preferred measure of inflation. Expect underlying capital goods orders (Monday) to show a further improvement, consumer confidence to have slipped a bit but remain strong with home prices continuing to rise (both Tuesday), pending home sales (Wednesday) to rise, May consumer spending growth (Friday) to be a bit soft and inflation as measured by the core private consumption deflator (also Friday) to fall further to around 1.4%. The combination of which will probably keep the Fed on a tightening path but only gradually.

Eurozone consumer and business confidence readings (Thursday) are likely to show continued strength consistent with stronger growth, but core inflation (Friday) is likely to remain weak and below target at around 1% year-on-year.

Japanese data to be released Friday is expected to show continuing strength in labour market indicators (helped by a falling workforce), continued strong annual growth in industrial production and continuing weakness in inflation with core inflation remaining around zero.

Chinese business conditions PMIs (Friday) will also provide a look at how growth is holding up in June. Expect the official manufacturing PMI to remain around 51.

In Australia, ABS data (Tuesday) is expected to show the population having increased by another 1.5% through 2016, further fuelling underlying housing demand and helping support potential growth in the economy. In other data, expect job vacancies data for May to have remained solid consistent with ANZ job ads, new home sales to show a continuing gradual downtrend (both Thursday) and credit growth (Friday) to have remained modest, with most interest likely to be on whether the rate of growth in property investor credit is continuing to slow.

Outlook for markets

Shares are still vulnerable to a short-term setback as we are going through a weaker seasonal period for shares with risks around Trump, North Korea, Chinese growth, the Fed and the Australian economy all providing potential triggers. However, valuations remain okay – particularly outside of the US, global monetary conditions remain easy and profits are improving on the back of stronger global growth, so we continue to see the broad 6-12 month trend in shares remaining up. 

Low yields point to low returns from sovereign bonds.  

Unlisted commercial property and infrastructure are likely to continue, benefitting from the ongoing search for yield, but this will wane eventually as bond yields trend higher. 

National residential property price gains are expected to slow, as the heat comes out of Sydney and Melbourne. 

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.

Our view remains that the downtrend in the $A from 2011 will resume this year. The rebound in the $A from the low early last year of near $0.68 has lacked upside momentum, the interest rate differential in favour of Australia is continuing to narrow and will likely reach zero early next year (as the Fed hikes rates and the RBA holds or cuts) and commodity prices will also act as a drag (particularly the plunge in the iron ore price). Expect a fall below $US0.70 by year end.

Eurozone shares fell 0.4% on Friday but the US S&P 500 rose 0.2% helped by strength in tech stocks. Reflecting the small positive US lead, ASX 200 futures rose 3 points or 0.1% pointing to a flat to marginally positive start to trade on Monday morning.

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'Super flows' likely helping Australian shares

Monday, June 19, 2017

By Shane Oliver

Global share markets were soft over the last week, with US shares up just 0.1% as tech stocks continued to correct, Eurozone shares down 0.8%, Japanese shares down 0.4% and Chinese shares down 1.6%. Australian shares managed a decent 1.7% rebound, as they were due for a bounce after having fallen 5% from early May highs and fund flows into superannuation ahead of a June 30 deadline for some members are likely providing a strong source of demand (which is likely to intensify into month end). Bond yields fell in the US on low US inflation data, but were little changed elsewhere. Prices for oil, gold and copper fell but iron ore managed a gain. The $A had a bounce thanks to stronger Australian jobs data.

Super boost to Aussie shares

On the superannuation boost to Australian shares this month, it’s interesting to note that while Australian consumers remain sceptical about shares as the “wisest place for their savings”, their interest in superannuation has picked up (albeit from a low base) presumably in response to recent super reforms which allow for large, one-off contributions prior to June 30. Something similar was seen in mid-2007. It’s also noteworthy how sceptical Australians remain of real estate (relative to the historical norm) according to the survey. But this has been the case for more than a year now and it hasn’t stopped further gains in Sydney and Melbourne property prices, at least until recently.

Source: Westpac/Melbourne Institute, AMP Capital 

The Fed hikes rates

The Federal Reserve provided no surprises with its fourth rate hike this cycle, no change to the so-called dot plot path for expected future interest rate hikes, some details around how it will slow reinvesting in bonds as they mature to allow its balance sheet to start returning to normal, and the usual assurances that the removal of easy money will be gradual and conditional on the economy behaving as expected.

Our view is that the Fed will hike rates once more this year in September, and commence balance sheet reduction in the December quarter. However, ongoing benign inflation is likely to see a slower path of rate hikes in 2018 and 2019 than the dot plot is implying. The absence of significant upside inflation pressures mean the Fed will remain benign and unlikely to pose a threat to US or global growth and hence share markets. 

In some ways, the situation in the US resembles the bond conundrum that Fed Chair Alan Greenspan observed in 2005. Tightening monetary policy and yet falling or low bond yields at the same time as a strong share market. While this might seem contradictory then as now it reflects reasonable growth but low inflation. Of course, back then bond yields did eventually rise but it morphed into what was commonly called “goldilocks”, “pleasantville” or “the great moderation”. Ultimately, it came to an end after excessive risk taking but it lasted for longer than many expected.

Trump noise

The noise around President Trump and Russia links continues, with talk that Trump was thinking of sacking Special Counsel Bob Mueller, who is investigating the links and then-news that Mueller was looking into a possible obstruction of justice by Trump - the leak of which may have been motivated to get Trump to back off. All of which saw an amusing tweet from Trump: “They made up a phony collusion with the Russians story, found zero proof, so now they go for obstruction of justice on the phony story. Nice.”

Source: AAP

Mueller’s probe will probably find something somewhere, even if it is not related to the Russia link. Reminds me a bit of the twists that the investigation into President Clinton took, from Whitewater to Monica Lewinsky. Our view remains that while the Democrats may find something to impeach Trump on when they get control of the House of Representatives after the November 2018 mid-terms, in the meantime, the Republicans are unlikely to impeach Trump. Rather, anticipation of the likely loss of control of Congress after November next year will see Republicans pull together to pass their pro-business agenda, including around healthcare and tax reforms. The shooting of Republican Congressional members only adds to this.

French parliamentary election 

A likely parliamentary majority for President Macron’s Republic on the Move party at Sunday’s final round French parliamentary election is probably already factored in by markets. Nevertheless, it will be a momentous occasion, with the French about to head down a market-oriented reform path starting with labour market reforms, and clearing the way for France to work with Germany to strengthen the Eurozone. The French elections coming on the back of pro-Euro outcomes in Spain, Austria and the Netherlands and almost certainly in Germany highlight diminishing political risk in the Eurozone.

While Italy remains a risk, the waning of populist support across Europe may have a spill over in Italy, the Eurosceptic Five Star Movement is unlikely to be able to form government and, in any case, the risk of a domino-like flow on from Italy to the rest of the Eurozone looks to be in retreat. Similarly, while Catalonia in Spain is aiming to have another independence referendum in October, it should be noted that polls of Catalonians show that most favour more autonomy within Spain, not independence. All of which, along with attractive valuations and a supportive ECB, is positive for Eurozone shares.

Major global economic events and implications

US data was a bit messy but consistent with reasonable growth and continuing low inflation. May retail sales were soft but already solid April sales were revised up and, in any case, regional manufacturing conditions surveys were strong in June, small business optimism remains very high, home builder conditions remain strong and unemployment claims remain around their lowest since the early 1970s.

May housing starts were weak, but are likely to bounce back given strength in other housing related indicators. Meanwhile, core CPI inflation was weaker than expected in May at 1.7% year on year. The US economy continues to look good but the lack of inflation pressure means the Fed can afford to remain gradual.

The Bank of England left rates on hold but it was more hawkish than expected. The risk of a rate hike has gone up, but Brexit uncertainty will keep the BoE on hold for a while yet. 

The Bank of Japan remained on autopilot as expected as it has committed to continuing quantitative easing and targeting a zero 10-year bond yield until inflation exceeds 2%.

Chinese activity data and credit growth for May points to growth holding up. While fixed-asset investment slowed a touch, growth in retail sales and industrial production was unchanged. While money supply growth slowed, owing to a slower shadow bank and mortgage lending, overall credit growth edged up slightly to 14.7% year on year. The overall picture is that Chinese growth has slowed after the acceleration seen earlier this year but that it remains solid at around 6.5%.

India saw a nice combination of stronger-than-expected industrial production in April and weaker than expected inflation. It remains a bright spot in the emerging world, although its share market valuations already reflect that.

Australian economic events and implications

Australian data was a bit more upbeat over the last week. While consumer confidence fell further below its long-term average, highlighting the negative impact of poor wages growth, high underemployment, rising electricity prices, etc., on households, business conditions and confidence remained solid and jobs data surprised on the upside for the third month in a row, taking the unemployment rate down to its lowest since early 2013. While the boom in jobs over the last three months should be treated with some caution, it is consistent with forward-looking labour market indicators and the jobs data, along with solid business conditions, provide a bit of an offset to other recent more negative data. The jobs data and the NAB survey support the RBA in leaving interest rates on hold for now. But, given softer data for growth, consumer spending, housing construction, non-mining investment and wages growth, our view remains that there is more risk of another rate cut than a rate hike in the next 12 months or so.

For a decade or more, political dysfunction has played havoc with Australia’s energy supply – as the uncertainty around energy policy has led to underinvestment in new capacity by both clean and dirty sources of energy - and we are now paying the price. Not only in terms of getting our emissions down, but also in terms of surging energy prices weighing on households and businesses. This is set to continue, with price rises of up to 20% this year. The problem is widely recognised but unless we can put politics aside and get agreement around energy policy – with the Finkel review providing a way forward - then the problem will only worsen and we will lose businesses and jobs to countries who have got their act together on this front.

What to watch over the next week?

In the US, Markit business conditions PMIs (Friday) are likely to remain solid at around 53 for manufacturing and 54 for services. Meanwhile, both existing home sales (Wednesday) and new home sales (Friday) are expected to rise after weakness in April and home prices are expected to show continuing strength.

Eurozone business conditions PMIs for June to be released Friday are expected to remain strong at around 56-57.

Japan’s manufacturing conditions PMI for June will also be released Friday.

In Australia, a speech by RBA Governor Lowe (Monday) will be watched for any clues on interest rates, albeit I don’t expect any. The minutes from the RBA’s last board meeting (Tuesday) will also be released with most interest likely to centre around how it sees the housing market given recent signs of a cooling in Sydney and Melbourne. March quarter ABS house price data (Tuesday) will likely show growth of around 3% quarter on quarter consistent with private surveys, but this data will be very dated given APRA’s latest tightening measures came at the end of March and since then CoreLogic data has shown a distinct softening in home prices since. 

Outlook for markets

Shares are still vulnerable to a short-term setback as we are going through a weaker seasonal period for shares with risks around Trump, North Korea, Chinese growth, the Fed and the Australian economy all providing potential triggers.

However, valuations remain okay – particularly outside of the US, global monetary conditions remain easy and profits are improving on the back of stronger global growth, so we continue to see the broad 6-12 month trend in shares remaining up. 

Low yields point to low returns from sovereign bonds.  

Unlisted commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this will wane eventually as bond yields trend higher. 

National residential property price gains are expected to slow, as the heat comes out of Sydney and Melbourne. 

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.

Our view remains that the downtrend in the $A from 2011 will resume this year. The rebound in the $A from the low early last year of near $0.68 has lacked upside momentum, the interest rate differential in favour of Australia is continuing to narrow and will likely reach zero early next year (as the Fed hikes rates and the RBA holds or cuts) and commodity prices will also act as a drag (particularly the plunge in the iron ore price). Expect a fall below $US0.70 by year end. 

Eurozone shares rose 0.6% on Friday and the US S&P 500 gained 0.1%, but with tech stocks still dragging. The positive global lead and a rise in iron ore prices saw ASX 200 futures rise 9 points or 0.2% pointing to a mildly positive start to trade for the Australian share market on Monday.

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Weak or negative GDP growth?

Monday, June 05, 2017

By Shane Oliver

Share markets rose over the last week, helped by mostly good economic data and expectations that central banks will remain benign. US shares rose 1% to a new record high, Eurozone shares gained 0.5%, Japanese shares surged 2.5%, Chinese shares rose 0.2%, and Australian shares gained 0.6%. While bond yields rose in Italy on early election fears, they were flat in Australia and Japan and fell in core Europe and the US, after softer-than-expected US jobs data. Commodity prices mostly fell, but a weaker $US resulted in little change in the $A.

Are things so bad?

Are things so bad equity managers should hand all their funds back to their clients as one Australian manager is reported to have done? Putting aside speculation around other issues that may have driven the decision, there are several points to make in relation to this. First, shares globally are at risk of a correction but the combination of improved growth including solid business conditions (see the next chart), rising profits, okay valuations and low interest rates indicates the broad backdrop is reasonable.

Second, risks remain around China, but they have long been there and there is no indication it’s suddenly about to fall over. Similarly, I am expecting a pullback in Sydney and Melbourne property prices and the Australian economy remains weak, but it’s doubtful that it’s on the edge of the abyss. Fourthly, over the years, there have been numerous high profile calls to “sell everything” or “gear up big time for the great boom ahead”. Some get lucky but many not, the point being that it’s dangerous to bet everything on one big call. Finally, individual fund managers are usually chosen to fill a role in a portfolio of assets, which has been carefully constructed to meet investment goals over time with the expectation that each fund manager will manage the assets in their care in line with their process and views. So, if one manager decides to give the money back, the manager of the whole portfolio – be that a financial planner, super fund, or individual - will invariably just have to find another manager to fill the gap.

Source: Bloomberg, AMP Capital

US leaves Paris climate agreement

US President Donald Trump’s decision to leave the Paris climate agreement will have little short-term impact on markets but poses a longer-term negative for the US (and for global warming). Short term, it’s of little consequence for investment markets. It will take time for the US to exit and several key US states (notably, California) will uphold the Paris agreement and more anyway. Longer term, it’s another delay in doing something about climate change and the US will pay some price as the rest of the world pushes faster towards renewables, leaving the US behind. Of course, the next US President will likely sign up again but the delay is not helpful.

Early Italian election?

Just when it seemed "Eurozone break up risks" would be quiet for a while, there is renewed talk of an early Italian election. Their next election is due by May next year, but signs of agreement on electoral reform and a desire on the part of the governing Democratic Party to get an election out of the way before a contractionary budget due later this year, have raised again the prospect of an early election around September-October. With the populist, mostly anti-Euro Five Star Movement (5SM) tied in the polls with PD, there is a good chance that it will win the most seats. However, it's doubtful 5SM will be able to agree a coalition with the right wing Eurosceptic Northern League (which, at times, has advocated a break up of Italy). In which case, Italy will revert to a coalition involving the current government and the idea of Italy leaving the Euro will recede again. None of this will stop markets from worrying about it in the interim. But one thing that helps fade the risk of a Eurozone break up is that the elections in Europe since the Brexit vote have seen the rejection of anti-Euro parties, suggesting the risk of Italy setting off a domino effect across Europe of countries seeking to leave the Euro is low. As such, we remain upbeat on Eurozone shares.

Major global economic events and implications

US data was mostly good, with a solid May manufacturing conditions ISM, consumer confidence down a bit but still very strong, solid gains in personal income and spending in April and continued increases in home prices. US jobs data was mixed though, with payrolls up by a less-than-expected 138,000 in May, but with unemployment falling to 4.3%, underemployment falling to near pre-GFC lows, jobless claims at early 1970s levels and other job indicators remaining robust, it’s hard to conclude that the US jobs market is anything other than strong. As a result, the Fed remains on track to hike rates again this month. However, the lack of any significant acceleration in wages growth (it was just 2.5% year-on-year in May) along with core private consumption deflator inflation falling to 1.5% year-on-year in April, will keep the Fed gradual and it may even lower it’s so-called “dot plot” of rate hike expectations for next year.

Eurozone core inflation also fell in May, back to 0.9% yoy, which explains why, despite stronger activity data including another decline in unemployment and strong confidence readings, ECB President Draghi remains dovish.

Japanese data remained mixed, with strong labour market data, industrial production and a rise in the manufacturing conditions PMI but weak household spending. Depressed wages growth remains an ongoing constraint.

Chinese business conditions PMIs were confusing in May, with stronger services conditions, a flat official manufacturing PMI but a further decline in the Caixin manufacturing conditions PMI. Averaging them out suggests stable growth after the slowdown of the last few months.

Australian economic events and implications

Australian data over the last week was messy. Building approvals bounced, but the trend remains clearly down. Retail sales bounced in April allaying fears, for now, of a consumer collapse and setting up a stronger June quarter, but the bounce looks partly due to better weather and the timing of Easter and the consumer remains under some pressure. Business investment was flat in the March quarter, mining investment looks like it’s getting close to the bottom and investment plans point to a slowing in the pace of decline in business investment, but it’s still falling (see the next chart). 

Source: ABS, AMP Capital

Our estimate for March quarter GDP growth remains 0.1%, but given normal forecasting errors, a negative outcome is a very high risk.

With consumers under pressure, and the impact of Cyclone Debbie on coal exports risking a negative June quarter, there is a possibility of a technical recession. Of course, solid forward looking jobs indicators, a slowing drag from falling mining investment, and strong public capital spending all argue against getting too gloomy, but the overall picture is one of sub-par growth running well below that assumed by the RBA and in the Budget.

In our view, this all points to the rising risk of another interest rate cut, a continuation of the relative underperformance of Australian shares compared to global shares that started in 2009, and a break in the value of the $A below $US0.70.

House prices

On the house price front, CoreLogic data for May adds to evidence that the peak, at least in terms of momentum, has been seen. The drip feed of negative news regarding the Sydney and Melbourne property markets - bank rate hikes, APRA moves, surging unit supply, tightening conditions for investors and foreign buyers (with NSW moving again on foreign buyers in the last week), constant warnings of a bubble about to burst - is starting to impact. Overall, our view remains that the peak in home price growth in Sydney and Melbourne has been seen and that further weakness lies ahead, with ultimately a 5 to 10% average decline, and that unit prices in parts of Sydney and Melbourne will fall by 15-20%. In the absence of much higher interest rates, much higher unemployment and a generalised oversupply a property crash (say a 20% plus fall in average home prices is unlikely). Of course, it’s dangerous to generalise across Australia – Perth property prices are probably getting close to the bottom and Brisbane and Adelaide prices are likely to continue meandering along at around 3% year on year.

What to watch over the next week?

In the US, expect the non-manufacturing conditions ISM (Monday) to remain strong at around 57 and job openings and hiring (Tuesday) to remain solid.

The European Central Bank (Thursday) is expected to leave monetary policy on hold. While it may move to characterise the risks around its forecasts as being balanced reflecting recent strong economic activity related indicators President Draghi is likely to remain dovish and stress the need for ongoing monetary support given the lack of upwards pressure on underlying inflation. Political uncertainty around Italy will also help keep the ECB dovish.

The UK election (Thursday) has turned into a more interesting affair with the Government's poll lead declining. The most likely scenario remains that the Tories are returned with some increase in seats, which would have little bearing on Brexit. Alternatively, if Labour wins, Brexit may turn out to be softer, but expect to see a return to a pre-Thatcher world of far greater government involvement in the economy which will not augur well for productivity (oddly at a time when the French are going in the opposite direction). Either way, there are likely to be minimal implications for the global economy or Europe, which since the Brexit vote, has moved against populism.

Chinese trade data (Thursday) is likely to show export growth slowing to 7% year-on-year and import growth slowing to 9%. CPI inflation (Friday) is likely to have risen to 1.4% yoy, but producer price inflation is likely to slow to 5.5%.

Interest rates

In Australia, the RBA is likely to leave interest rates on hold for the tenth month in a row at Tuesday’s board meeting, as only a month has passed since it expressed more confidence around the outlook for growth and inflation. The RBA will likely also conclude that it’s way too early to declare victory in its efforts to slow the Sydney and Melbourne property markets, and recent strength in employment and business surveys also support the case to remain on hold for now. However, the chance of another rate cut by year end is steadily rising – growth looks like it will come in well below the RBA’s forecasts, thanks to weak consumer spending and business investment, along with slowing housing investment and subpar growth and record low wages growth is likely to keep inflation lower for longer too. In the meantime, the softening in the Sydney and Melbourne property markets will provide flexibility for the RBA to cut again if needed. The money market’s implied probability of a 20% chance of a rate cut by year end is way too low – it should probably be around 45%.  

March quarter GDP data

On the data front in Australia, the focus is likely to on March quarter GDP data to be released Wednesday, which is expected to show growth faltering again to just 0.1% quarter-on-quarter or 1.5% year-on-year, thanks to a combination of weak consumer spending, a fall in housing investment and a detraction to growth from trade.

However, data on profits and inventories (Monday) and public demand and net exports (Tuesday) will help firm up GDP forecasts and on this front, net exports are expected to be weak but public demand growth should be positive. The trade surplus for April (Thursday) is likely to show a sharp decline thanks to the impact of Cyclone Debbie on coal exports but this should reverse in May. Housing finance data for April (Friday) is likely to show a further decline. 

Outlook for markets

Shares remain vulnerable to a short term setback as we are now in a weaker seasonal period for shares with risks around Trump, North Korea, Chinese growth and the Fed’s next rate hike providing potential triggers. However, with valuations remaining okay – particularly outside of the US, global monetary conditions remaining easy and profits improving on the back of stronger global growth, we continue to see any pullback in shares as an opportunity to “buy the dips”. Shares are likely to trend higher on a 6-12 month horizon. 

Low yields and capital losses from a gradual rise in bond yields are likely to see low returns from sovereign bonds.  

Unlisted commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this demand will wane eventually as bond yields trend higher. 

National residential property price gains are expected to slow, as the heat comes out of Sydney and Melbourne. 

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.

For the past year, the $A has been range bound between $US0.72 and $US0.78, but our view remains that the downtrend in the $A from 2011 will resume this year. The rebound in the $A from the low early last year of near $0.68 has lacked upside momentum, the interest rate differential in favour of Australia is continuing to narrow and will likely reach zero early next year (as the Fed hikes rates and the RBA holds or cuts) and commodity prices will also act as a drag (particularly the plunge in the iron ore price). Expect a fall below $US0.70 by year end.

Eurozone shares rose 0.6% on Friday and the US S&P 500 gained 0.4% helped by expectations that softer than expected US employment growth for May and slow wages growth will keep the Fed benign. Reflecting the positive global lead ASX 200 futures rose by 0.5% on Friday night, pointing to a roughly 25 point gain in the Australian share market when it opens on Monday morning.

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Will Aussie shares continue to underperform?

Monday, May 29, 2017

By Shane Oliver

Share markets rose over the last week, reversing the Trump FBI/Russia bump from the previous week as investors bought the dip, supported by mostly good economic and profit news. US shares rose 1.4%, Eurozone shares rose 0.04%, Japanese shares gained 0.5%, Chinese shares rose 2.3%, and Australian shares gained 0.4%. The gains in Australian shares were constrained by ongoing worries about the banks, retail shares and weakness in the iron ore price. Bond yields were flat to down, commodity prices were weak, with iron ore down 7.6%, but the $A was little changed. 

Terrorism rears its ugly head

The past week saw terrorism rear its ugly head again, this time in Manchester in the UK and our thoughts are with those affected. Despite some fears to the contrary, the financial market impact proved, yet again, to be minor with UK shares only falling 0.1% the next day before rebounding and there was no sign of any impact on other share markets.

This is consistent with the experience since early last decade that has highlighted that terrorist attacks on targets like crowds, buildings and entertainment venues, etc., don’t really have much economic impact. While the 9/11 attacks had a big short-term share market impact, with US shares falling 12%, they had recovered in just over a month; the Bali and Madrid bombings had little impact; the negative 1.4% impact on the UK share market from the London bombings of July 2005 was reversed the day after; the French share market only fell 0.1% the next trading day after the November 2015 Paris attacks and 0.3% the day after the July 2016 Nice attack.

The experience across the UK and Europe with the IRA, ETA, Red Brigades, the Red Army Faction, etc., in the 1970s and 1980s highlights that terrorist attacks can come to be seen as the norm, with people getting desensitised to them. So, while terrorism is horrible for those affected, it would need to cause more damage to economic infrastructure to have a significant economic impact and hence a significant impact on investment markets.

Moody's downgrades China's sovereign credit rating

Moody's downgrading of China's sovereign credit rating from Aa3 to A1 is unlikely to have much impact. China's debt problems are well known, with China's policy makers seeking to restrain debt, most investment in Chinese bonds is internally sourced and China is not dependent on foreign capital being the world's largest credit nation.

OPEC agrees to extend production cuts

As widely expected, OPEC agreed to extend its production cuts to March next year, but for the oil price, it was a classic case of “buy on the rumour, sell on the fact.” OPEC is basically in a bind: if it cuts supply further it will lose more market share to shale oil, but if it hiked production, oil prices will plunge again. So, it chose the middle path.

Trump's Budget

President Trump's fuller budget request released in the last week is best ignored. As always, Congress will put the budget together - Trump doesn't even need to sign it off.

Aussie bank downgrades

The latest Australian bank rating downgrades tell us nothing new, but the drip feed of negative news around the property market in Sydney and Melbourne is continuing to mount - surging unit supply, bank rate hikes, tightening lending standards, reduced property investor tax deductions, ever tighter restrictions around foreign buyers, etc. Our view remains that home price growth has peaked in Sydney and Melbourne and that price declines lie ahead, particularly for units. The extent of the unit construction boom in Sydney is highlighted by the residential crane count, which has increased from just 62 in September 2014 to 292 in March. 

Source: Rider Levett Bucknall Crane Index, AMP Capital

Global over Aussie shares

Still prefer global over Australian shares. Much of the relative underperformance of the Australian share market versus global shares since 2009 - which reflected relatively tighter monetary policy in Australia, the commodity slump, the lagged impact of the rise in the $A above parity and a mean reversion of the 2000 to 2009 outperformance - has been reversed.

However, the Australian share market looks likely to continue underperforming going forward, reflecting weaker growth prospects in Australia - with the economy looking like it may have stalled again in the March quarter, the housing cycle peaking and turning down, constraints on consumer spending (high debt, higher bank lending rates, slowing wealth affects, rising energy costs, record low wages growth and high underemployment), risks around the banks and uncertainty around the outlook for bulk commodity prices.

We still see the ASX 200 higher by year end, but global shares are likely to do better on both a hedged, and particularly unhedged, basis.

Source: Thomson Reuters, AMP Capital

Major global economic events and implications

US data was mostly good, with the highlight being a rise in the overall business conditions PMI for May pointing to reasonable growth. Meanwhile, home sales fell, but home prices continued to rise, and March quarter GDP growth was revised to 1.2% annualised, from 0.7%. The main dampeners were weaker-than-expected trade, inventory and durable goods data. The minutes from the last Fed meeting confirmed that the Fed is likely to hike rates again in June and looks to be on track to start running down its balance sheet (i.e, reversing quantitative easing) from later this year by letting a gradual amount of maturing bonds roll off each month. Rate hikes and balance sheet reduction all remain conditional on the economy continuing to behave though.

Eurozone business conditions PMIs remained very strong in April and business confidence rose in Germany and France, which is all consistent with strengthening growth in Europe. 

Japanese inflation rose slightly in April, but with core inflation still zero, the Bank of Japan is set to continue quantitative easing and its zero 10-year bond yield policy for a long time.

Australian economic events and implications

Australian March quarter construction data fell, adding to the downside risks to March quarter GDP growth. However, it’s not all bad as the 4.7% slump in residential construction looks temporary and likely to reverse in the current quarter as the impact of Cyclone Debbie drops out and the huge pipeline of work yet to be completed kicks in. Also, public construction is up strongly reflecting state infrastructure activity, and December quarter construction activity was revised up significantly.  

Weak March quarter construction activity, along with very weak retail sales and a likely growth detraction from net exports, highlights that absent an upside surprise in public spending, equipment investment or inventories, March quarter GDP growth looks likely to be near zero with the risk of another contraction. Reflecting this, along with ongoing softness in underlying inflationary pressures, there is far more risk of another RBA rate cut by year end than a rate hike.

What to watch over the next week?

In the US, the focus is likely to be on the May ISM manufacturing conditions index (Thursday) and jobs data (Friday). The ISM is likely to have remained solid at around 55 and jobs data is likely to have remained strong with a 175,000 rise in payroll employment and unemployment remaining unchanged at 4.4%, but wages growth modest at around 2.7% year on year (yoy). In other releases, expect solid growth in April consumer spending, but a fall back in inflation as measured by the core personal consumption deflator to 1.5% yoy and consumer confidence in May to have remained strong (all due Tuesday), pending home sales (Wednesday) to reverse a fall seen in March, and the April trade deficit (Friday) to deteriorate.

Eurozone business and consumer confidence readings for May (Tuesday) are expected to remain solid and unemployment (Wednesday) is likely to have fallen to 9.4% from 9.5%, but core inflation is likely to fall back to 1% yoy from 1.2% reversing a distortion in April due to Easter.

Japanese jobs data for April is expected to remain solid - helped of course by a falling workforce, but household spending data is likely to remain weak (all due Tuesday) and industrial production data (Wednesday) is likely to show a bounce.

Chinese business conditions PMIs (Tuesday and Wednesday) are expected to soften marginally.

In Australia, expect building approvals (Tuesday) to show a 3% gain after a sharp fall in March, credit growth (Wednesday) to remain moderate, CoreLogic data to show a further moderation in home price growth, retail sales to show a 0.2% bounce after several soft months and March quarter business investment data to show a 0.5% decline as mining investment continues to fall (all due Thursday). Of most interest in the investment data will be investment intentions which are expected to show some improvement in non-mining investment.

Outlook for markets

Shares remain vulnerable to a further short-term setback as we are now in a weaker seasonal period for shares with risks around Trump, North Korea, Chinese growth and the Fed’s next rate hike providing potential triggers. However, with valuations remaining okay – particularly outside of the US, global monetary conditions remaining easy and profits improving on the back of stronger global growth - we continue to see any pullback in shares as an opportunity to “buy the dips”. Shares are likely to trend higher on a 6-12 month horizon. 

Low yields and capital losses from a gradual rise in bond yields are likely to see low returns from sovereign bonds.  

Unlisted commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this demand will wane as bond yields trend higher. 

National residential property price gains are expected to slow, as the heat comes out of Sydney and Melbourne. 

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.

For the past year the $A has been range bound between $US0.72 and $US0.78, but our view remains that the downtrend in the $A from 2011 will resume this year. The rebound in the $A from the low early last year of near $0.68 has lacked upside momentum, the interest rate differential in favour of Australia is continuing to narrow and will likely reach zero early next year (as the Fed hikes rates and the RBA holds or cuts) and commodity prices will also act as a drag (particularly the plunge in the iron ore price). Expect a fall below $US0.70 by year end.

Eurozone shares fell 0.1% on Friday and the US S&P 500 rose just 0.03%. ASX 200 futures gained 7 points or 0.1% on Friday night pointing to a flat to slight positive start to trade for the Australian share market on Monday morning, although a further 3.9% plunge in the iron ore price is likely to weigh on mining stocks.

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