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

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

Monday, April 24, 2017

By Shane Oliver

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

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

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

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

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

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

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

Source: Bloomberg, AMP Capital

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

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

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

Source: Bloomberg, AMP Capital

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

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Weekly economic and market update

Monday, April 10, 2017

By Shane Oliver 

Share markets were mixed over the last week, with ongoing nervousness regarding whether US President Donald Trump will pass his pro-business reforms, the Fed signalling a likely start to reducing its balance sheet later this year, and a US missile strike against Syria injecting a bit of uncertainty. US shares fell 0.3%, Eurozone and Australian shares were flat, Japanese shares lost 1.3%, but Chinese shares rose 1.5%. Bond yields and the $A fell, but oil and gold prices rose.

US missile strike

While the US missile strike against Syria in response to a chemical attack on its civilians caused a bit of uncertainty in financial markets, it looks to have been trivial and short lived as has been the case in the past in response to limited military strikes and most terrorist attacks. This is likely to remain the case, as the strike was highly targeted and proportional to the chemical attack and does not signal increased US involvement in Syria. One thing it does tell us though, is that the US is not withdrawing into isolationism under Trump as some feared - and that is a good thing.

Trump's tax agenda

In terms of the policy progress around President Trump: the resurrection of debate around healthcare reform is a negative, in that it could delay tax reform, but a positive in that if it’s successful, it could result in budget savings that make tax reform easier. The change to Senate rules to allow a simple majority of 51 to approve Neil Gorsuch to the Supreme Court will further enrage Democrats and risk more gridlock long term, but is unlikely to have much impact in the short term as the GOP has the 51 Senate votes. Talk of bringing back Glass-Steagall bank regulations won’t go anywhere, as there is no support for such a move in the US Congress. The meeting between Presidents Trump and Xi Jinping looks to have been focussed on getting to know each other, with Trump referring to an “outstanding” relationship with Xi, and that lots of “bad problems will be going away”, but at least the risk of a Trump-driven trade war will remain on the back burner. In short, lots of noise around all this – but as long as Trump’s pro-business agenda remains the focus, investment markets won’t be too fussed.

US Fed signals balance sheet reduction

The US Federal Reserve signals that the third phase of monetary policy normalisation – i.e. balance sheet reduction - is likely to get underway from later this year. The first phase was the tapering and then ending of quantitative easing (or QE) between January and October 2014, the second was the start of interest rate hikes in December 2015, and the third will be letting its balance sheet start to decline, with the minutes from last month's Fed meeting indicating that this is likely to be appropriate from later this year.

The Fed has long signalled that this will be achieved by not reinvesting (or rolling over) the proceeds from maturing bonds in its balance sheet and from the Minutes it looks to favour a phasing down of its reinvesting. The start of the first two phases in moving to more normal monetary policy were associated with corrections in share markets (the “taper tantrum” of mid-2013 and the correction in share markets between May 2015 and February 2016) as investors fretted the Fed will automatically wind back stimulus regardless of the economic impact. So, there is a risk of something similar happening in the months ahead, particularly given that share markets have been vulnerable to a correction for some time. However, there is no reason to get too fussed:

  • First, as the first two phases showed the Fed will not blindly start to run down its balance sheet, but it will be contingent on a continued improvement in the US economy, so it’s likely to be gradual and subject to stopping and starting if needed.
  • Second, balance sheet run down is likely to be a substitute for rate hikes, so if it commences this year it adds to confidence the Fed will only do two rate hikes this year and not three.
  • Finally, while it will involve a net increase in the supply of bonds in the market and so along with further rises in US interest rates points to a resumption of rising bond yields – the Fed won’t be actually selling bonds, so the rise in bond yields is likely to be gradual.
  • The bottom line though is that Fed balance sheet reduction, along with the end of quantitative easing and rate hikes, signal that the Fed’s efforts to support the US economy since the GFC have worked and that it’s appropriate to continue to take it off life support. This is a good thing.   

In contrast to the Fed, the ECB and Bank of Japan are yet to start even the first phase of monetary policy normalisation. Relative monetary policy still points to a strong $US against the Yen and Euro and against the $A with the RBA on hold. 

The French election

The first round of the French presidential election is now only two weeks away on April 23rd. Polls continue to show Le Pen and Macron on around 25% of the vote each. So, it remains likely they will make it through to the run-off on May 7, where polls show Macron leading Le Pen by around 20%. 

RBA on hold

RBA on hold and likely to remain so well into 2018. As widely expected, the RBA left the cash rate on hold at 1.5% for the eighth month in a row. The uncomfortably hot Sydney and Melbourne property markets, along with RBA expectations that GDP growth will return to around 3% and that underlying inflation has bottomed, argue against a rate cut. Against this, high unemployment and underemployment, the too high $A, fragile economic growth and downside risks to underlying inflation all argue against a hike.

Meanwhile, bank rate hikes, regulatory moves to tighten lending standards and hopefully action in the May budget on the capital gains tax discount should help deal with financial stability risks around house prices and household debt, giving the RBA flexibility to set rates in the best interest of the wider economy and not just the Sydney and Melbourne property markets. Our view is that rates have probably bottomed and that the next move will be a hike, but not until the second half of 2018.

The drip feed of negative news flow - bank rate hikes, tightening measures by APRA and ASIC, talk of increased bank capital requirements which will result in more out-of-cycle rate hikes and authorities and commentators warning about the risks - should at least help slow the Sydney and Melbourne property markets. For investors who think that the 10-15% pa average home price gains of the last four-five years are a guide to the future, it's worth having a look at Perth home prices which are where they were ten years ago. Ten years of zero capital growth in Sydney and Melbourne would mean a housing return of just the net rental yield which is 2% or less.  

Major global economic events and implications

US data was mostly solid, with still strong readings for ISM business conditions indexes, strong jobs data apart from payroll employment, a rise in construction spending and a better-than-expected trade deficit. A fall in auto sales and weak payroll employment growth of just 98,000 in March were the main negatives. However, the slowdown in payroll employment looks weather related and with the household employment survey up strongly and unemployment falling to just 4.5% the Fed remains on track to continue normalising monetary policy but with wages growth running at just 2.7% year-on-year, the Fed will remain gradual.

Eurozone retail sales rose more than expected in February and unemployment continued to fall, reaching 9.5%. While unemployment is still high from a growth perspective, it’s the direction that counts and it's down from a high of 12.1% in 2013.

Japanese business conditions surveys showed further improvement in March and consumer sentiment is up - all of which points to reasonable economic growth.

Australian economic events and implications

Australian data highlighted why the RBA needs to remain on hold. On the one hand, March house prices rose strongly, the AIG’s manufacturing and service conditions PMIs were solid, job ads rose, building approvals rebounded and the trade surplus rose to a near record. Against this, February retail sales were soft, building approvals look to have peaked, the near-record trade surplus partly reflected weak imports which is a negative and in any case will fall in the next month or so thanks to Cyclone Debbie’s hit to coal exports and the MI Inflation Gauge showed underlying inflation remaining weak in March.

What to watch over the next week?

In the US, March quarter earnings reports will start to flow, with the consensus looking for a 9.7% gain on a year ago which is likely to be exceeded as expectations have been depressed by a high level of downgrades lately. On the data front, expect small business optimism and job openings (Tuesday) to remain strong and March retail sales (Friday) to perk up a bit reflecting strong jobs and confidence readings. March quarter CPI inflation (Friday) is expected to fall back slightly, but core inflation is expected to come in around 2.3% year-on-year which is around where it’s been for some time.

In China, expect March CPI inflation (Wednesday) to rise to 1.2% year on year after February's surprise fall to 0.8%, but producer price inflation to slow to 7.5% year-on-year (from 7.8%) as positive momentum in commodity prices has faded. Trade data (Thursday) is likely to show a slowing in import growth to 20% year-on-year but a pick-up in export growth to 10% year-on-year. 

In Australia, expect flat housing finance (Monday), continued strength in business conditions according to the NAB business survey (Tuesday), consumer confidence remaining around its long-term average (Wednesday) and a 30,000 bounce in employment (Thursday) in March with unemployment remaining at 5.9%. The housing finance data will be watched closely to see whether the surge in lending to property investors continued in February. The RBA's latest Financial Stability Review is likely to reiterate the Bank's recent concerns regarding financial stability risks flowing from excessive growth in home prices and household debt - but this is likely to be a bit dated given that the regulators have already moved. 

Outlook for markets

Shares remain vulnerable to a short-term pull back as investor sentiment towards them is very bullish and a lot of good news has been factored in which has left them vulnerable to any bad news. But putting short-term uncertainties aside, with valuations remaining okay, global monetary conditions remaining easy and profits improving on the back of stronger global growth, we continue to see any pullback in shares as an opportunity to “buy the dips”. Shares are likely to trend higher on a 6-12 month horizon. 

With the Australian share market having broken decisively above the 5800 level, it now looks like it’s on its way to a retest of the March/April 2015 intraday highs of just below 6,000.

Still low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds. At present, bond yields are still consolidating after last year’s rise, but a resumption of the bear market is likely at some point in the months ahead seeing a gradual rise in yields. 

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

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

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

For the past year, the $A has been range bound between $US0.72 and $US0.78 and this may continue for some time. At some point this year though, the downtrend in the $A from 2011 is likely to resume as the interest rate differential in favour of Australia narrows (as the Fed hikes rates and the RBA holds) and as the Fed eventually moves to reduce its balance sheet and hence narrow measures of US money supply.

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

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Will APRA's move cool Sydney and Melbourne property?

Monday, April 03, 2017

By Shane Oliver

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

UK starts divorce proceedings

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

Trump-land troubles

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

APRA's move

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

Source: APRA, AMP Capital

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

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

Impacts of Cyclone Debbie

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

Major global economic events and implications

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

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

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

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

Australian economic events and implications

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

What to watch over the next week?

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

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

RBA expected to leave rates on hold

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

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

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

Outlook for markets

Shares remain vulnerable to a short-term pull back as investor sentiment towards them is very bullish and a lot of good news has been factored in, which has left them vulnerable to any bad news. But putting short term uncertainties aside, with valuations remaining okay, global monetary conditions remaining easy and profits improving on the back of stronger global growth, we continue to see any pullback in shares as opportunities to “buy the dips”. Shares are likely to continue to trend higher on a 6-12 month horizon. 

With the Australian share market having broken decisively above the 5800 level, it now looks like it’s on its way to a retest of the March/April 2015 intraday highs of just below 6000.

Still low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds. At present, bond yields are still consolidating after last year’s rise, but a resumption of the bear market is likely at some point in the months ahead seeing a gradual rise in yields.  

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

National residential property price gains are expected to slow to around 3-4% this year, as the heat comes out of Sydney and Melbourne. 

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

For the past year, the $A has been range bound between $US0.72 and $US0.78 and this may continue for some time yet. At some point this year though, the downtrend in the $A from 2011 is likely to resume as the interest rate differential in favour of Australia narrows (as the Fed hikes 3 or 4 times and the RBA remains on hold).

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

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Trump's pro-business agenda remains on track

Monday, March 27, 2017

By Shane Oliver

Investment markets and key developments over the past week

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

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

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

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

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

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

Major global economic events and implications

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

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

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

Australian economic events and implications

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

What to watch over the next week?

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

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

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

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

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

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

Outlook for markets

Shares remain vulnerable to a short term pull back of around 5% as investor sentiment towards them is very bullish and a lot of good news has been factored in which has left them vulnerable to any bad news as the uncertainty around Trump’s pro-business agenda showed over the last week. However, we would see any pullback as an opportunity to “buy the dips” as valuations are okay, global monetary conditions remain easy and global profits are accelerating on the back of stronger global growth. So shares are likely to continue to trend higher on a 6-12 month horizon.

Still low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds. At present bond yields are still consolidating after last year’s rise, but a resumption of the bear market is likely at some point in the months ahead seeing a gradual rise in yields. 

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

National residential property price gains are expected to slow to around 3-4% this year, as the heat comes out of Sydney and Melbourne.

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

For the past year the $A has been range bound between $US0.72 and $US0.78 and this may continue for some time yet. At some point this year though, the downtrend in the $A from 2011 is likely to resume as the interest rate differential in favour of Australia narrows (as the Fed hikes 3 or 4 times and the RBA remains on hold).

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

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

Monday, March 20, 2017

By Shane Oliver

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

The Netherlands election

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

The US Federal Reserve

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

 

Source: Bloomberg, Federal Reserve, AMP Capital

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

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

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

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

Source: RBA, AMP Capital

Major global economic events and implications

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

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

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

Australian economic events and implications

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

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

Five reasons why the RBA won’t hike this year

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

What to watch over the next week?

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

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

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

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

Outlook for markets

Shares remain vulnerable to a short term pull back as investor sentiment towards them is very bullish and a lot of good news has been factored in – but there is a risk that any pullback may not come until seasonal weakness kicks in around May. However, we see share markets trending higher over the next 12 months helped by okay valuations, continuing easy global monetary conditions, fiscal stimulus in the US, some acceleration in global growth and rising profits.

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

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

National residential property price gains are expected to slow to around 3-4% this year, as the heat comes out of Sydney and Melbourne and rising apartment supply hits. 

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

For the past year, the $A has been range bound between $US0.72 and $US0.78 and this may continue for some time yet. At some point this year though, the downtrend in the $A from 2011 is likely to resume as the interest rate differential in favour of Australia narrows (as the Fed hikes 3 or 4 times and the RBA remains on hold). 

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

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Fed on track for rate hike

Monday, March 13, 2017

By Shane Oliver

Investment markets and key developments over the past week

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

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

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

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

The RBA stays put

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

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

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

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

Major global economic events and implications

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

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

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

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

Australian economic events and implications

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

What to watch over the next week?

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

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

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

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

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

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

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

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

Outlook for markets

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

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

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

National residential property price gains are expected to slow to around 3-4% this year, as the heat comes out of Sydney and Melbourne and rising apartment supply hits.

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

For the past year, the $A has been range bound between $US0.72 and $US0.78 and this may continue for some time yet. At some point this year though, the downtrend in the $A from 2011 is likely to resume as the interest rate differential in favour of Australia narrows (as the Fed hikes three or four times and the RBA remains on hold).

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

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US Fed on track for March rate hike

Monday, March 06, 2017

By Shane Oliver

The past week saw US shares rise 0.7%, European shares gain 2.6% and Japanese shares rise 1% helped by strong US forward looking data, signs that the Fed is increasingly confident in the US outlook and confidence that President Trump is in on track with his pro-business agenda.

By contrast, Australian shares fell 0.2% and Chinese shares fell 1.3%. Bond yields generally rose as the probability of a March Fed rate hike rose, and this also saw the $US rise slightly, which in turn put downwards pressure on some commodity prices and the Australian dollar, notwithstanding a reversal on Friday.

Despite much anticipation, President Trump’s Congressional address provided little detail on his pro-business policies, but he made plenty of references to deregulation, corporate and personal tax cuts and infrastructure spending and he sounded more presidential. As a result, share markets remained happy. Interestingly, the Trump administration also sent to Congress its trade policy agenda, which made reference to pursuing bilateral trade deals and renegotiating existing deals, but does not signal the widespread application of tariffs, which adds confidence to the view that a trade war will be avoided.  

The US Fed on interest rates

There was more interest in relation to the Fed, where comments by various Fed officials that it should move “soon” to raise rates again, and that the risks were “starting to tilt to the upside” (backed up by Fed Chair Yellen and Vice Chair Fischer) saw the money market’s implied probability of a March rate hike rise to 94%.

Given the run of strong US data and with Yellen, Fischer and New York Fed President Dudley confirming that a March hike is likely, we have moved our timing for the next Fed rate hike from May/June to March. If this were happening a year ago, share markets would have gone into a tailspin. But, because the US economy is stronger now, the Fed’s confidence in the outlook actually seems to be supporting the share market. After the strong gains since the US election, the likelihood of a short-term share market correction remains high. That said, the US share market seems to be following the pattern seen in previous rate hiking cycles, i.e. a pullback around the first hike (February 1994, June 2004 and December 2015) and then rallying into and through subsequent hikes because economic data is better. Back in the 2004-2006, tightening cycle rates were going up at every Fed meeting and it took 17 hikes to ultimately kill the bull market off.

A March hike would potentially open the door to four Fed hikes this year, but compared to the 2004-2006 rate hike cycle, this time around the tightening process is likely to be a lot slower reflecting still constrained GDP growth (so far March quarter growth looks like being below 2% again), still low wages growth and the strong and rising $US. Consistent with this, Janet Yellen indicated that she sees no evidence the Fed is behind the curve and continues to see rate hikes as being “gradual”, albeit faster than in the last two years.

Source: Bloomberg, AMP Capital 

Housing market risks 

The OECD is right to warn about Australian house prices, excessive household debt and the risk to the economy. Such risks are real, particularly with Sydney home prices up 73% over the last five years against wages growth of just 13%. Housing - both affordability and the nexus of excessive home price and household debt growth - remains Australia's Achilles heel. It's worth noting though, that such warnings have been issued continuously since 2003 and yet the property market keeps on keeping on. Our view remains that unit prices in some oversupplied areas will fall 15-20% at some point and that a 5-10% cyclical downturn in average home prices is likely once interest rates start to rise. But, it remains hard to see a generalised home price crash in the absence of: much higher interest rates causing a wave of defaults (but the RBA is not going to raise interest rates until it gets to that point); a surge in unemployment (of which there is no sign at present); and a continuing surge in supply (but building approvals look to have peaked). While the property market is proving even stronger than I thought, my views on the risk of a property crash are unchanged from those in this note.

Major global economic events and implications

US data was mixed – but where it counts in the forward looking indicators, it was strong. On the soft side, December quarter GDP growth was left unchanged at 1.9%, pending home sales fell, construction fell, real consumer spending fell in January and the trade deficit widened. But more importantly, consumer confidence rose to its highest since 2001, unemployment claims fell to their lowest since March 1973 and the ISM conditions indexes rose to strong levels near 58.  

In the Eurozone, economic confidence rose to a new six-year high, adding to the message from business conditions PMIs that growth is likely to accelerate. Meanwhile, headline inflation rose to 2% year-on-year in February on higher energy prices, but core inflation remained stuck at 0.9%. 

Japanese industrial production fell in January, but a rising trend in the manufacturing conditions PMI points to a rebound going forward. Labour market data was strong, but household spending was weak and core inflation remained low at 0.2% year-on-year – but at least it’s up from 0.1%. The BoJ remains a long way away from tightening. 

Chinese manufacturing conditions improved in February and services conditions held strong consistent with growth remaining solid.

Rising export momentum across Asia – with Korean exports up 20% year-on-year – is consistent with the stronger global growth theme. Even Indian GDP growth surprised on the upside in the December quarter, despite “demonetisation”.

Australian economic events and implications

The Australian economy saw some good news with December quarter real GDP rebounding by a greater than expected 1.1% quarter-on-quarter, robbing the doomsters from being able to declare a recession. The rebound in real growth was broad based across consumer spending, public demand, housing investment, business investment and trade. Nominal growth was also strong reflecting higher commodity prices which, in particular, supported profits. While growth will likely slow back a touch in the current quarter on slower consumer spending and trade, it’s likely to be close to 3% through 2017. In other data, the trade surplus fell sharply in January, but this looks to be due largely to temporary factors including the early timing of the Chinese New Year holiday and a slump in volatile gold exports. Building approvals rose slightly in January and new home sales fell slightly but the trend is down in both, pointing to a loss of momentum in housing investment. House price growth though stayed uncomfortably strong in Sydney and Melbourne in February according to CoreLogic, adding to RBA wariness about cutting rates again.

The Australian December half-profit reporting season wrapped up and left listed company profits on track for a 19% rise this financial year after two consecutive years of falls. The profit turnaround has all been driven by resources companies which are on track for a rise in profit of 150% this financial year, reflecting the benefits of higher commodity prices and volumes on a tighter cost base. Profit growth across the rest of the market is likely to be around 5% but it should accelerate in 2017-18 as economic growth improves.

What to watch over the next week?

In the US, February jobs data on Friday will be watched very closely as it’s the last major data release ahead of the Fed’s March 15 meeting. Payrolls are expected to rise by around 190,000 with unemployment falling back to 4.7% and wages growth edging up. Coming on the back of a run of solid data releases, this should keep the Fed on track for a rate hike on March 15. Meanwhile, expect the January trade deficit (Tuesday) to worsen slightly.

The European Central Bank is expected to make no change to monetary policy on Thursday. It has already committed to continue its €60bn a month asset buying program to year end and it’s premature to expect any announcement regarding a 2018 taper, particularly with risks around the French election and core inflation remaining well below target at 0.9% year-on-year. 

Chinese import and export growth for February (Wednesday) is likely to show a further acceleration, with imports up 18% year-on-year and exports up 14% year-on-year, and while CPI inflation (Thursday) is likely to drop back to 2% year-on-year, producer price inflation is expected to accelerate further to 7.5% year-on-year. The National People’s Congress that starts Sunday is likely to confirm a growth target of around 6.5% for this year.

The Reserve Bank is expected to leave interest rates on hold when it meets Tuesday. Economic growth bounced back nicely in the December quarter, recent economic data has been reasonable (particularly business conditions surveys), national income is rising again and growth in Sydney and Melbourne property prices is too strong for comfort. As a result, we expect the RBA to leave the official cash rate at 1.5% and we now expect the RBA to leave rates on hold for the rest of the year. Another rate cut is still possible, but it would require another leg down in inflation to get the RBA to cut again. On the data front, expect January retail sales (Monday) to bounce back by 0.4% after a slight fall but housing finance (Friday) to fall by 1.5%.

Outlook for markets

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

Still low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds. Australian bonds are preferred to global bonds, reflecting higher yields and as the RBA is well behind the Fed in raising rates. 

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

National residential property price gains are expected to slow to around 3-4% this year, as the heat comes out of Sydney and Melbourne and rising apartment supply hits. 

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

The Australian dollar could still see a retest of $US0.78 which, if broken, would likely see a run up to $US0.80. However, the downtrend in the $A from 2011 is likely to resume at some point this year as the interest rate differential in favour of Australia narrows (as the Fed hikes three or four times and the RBA remains on hold).

Eurozone shares gained 0.3% on Friday and the US S&P 500 rose 0.05% as Fed Chair Yellen and Vice Chair Fischer confirmed that another rate hike is likely at the Fed’s mid-March meeting, but with Yellen indicating that rate hikes will likely remain “gradual”. Following the slightly positive global lead, ASX 200 futures gained 0.4% pointing to a 21-point gain at the open for the Australian share market on Monday, reversing half of Friday’s 0.8% decline. 

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Shares at risk of short-term correction

Monday, February 27, 2017

By Shane Oliver

The past week saw shares rise 0.9% in the US, 1.5% in China and 0.3% in Japan helped by more good economic data, but Eurozone shares fell 0.3% and Australian shares lost 1.2% as profit results became more mixed towards the end of the profit reporting season. Bond yields generally fell and commodity prices were mostly up. The $A was little changed.

While shares have generally continued to push higher, they remain at risk of a short-term correction being technically overbought again and with short term investor sentiment at levels often associated with corrections. A major misstep on economic issues by Trump, worries about Eurozone politics, policy tightening in China or signs of faster Fed rate hikes could all be a trigger. Trying to time this remains difficult though and we just see it as a correction (say with a 5% decline) rather than something more severe with the profit outlook (both globally and in Australia) continuing to improve.

Business conditions PMIs remain strong in February, with Europe and Japan up but the US down slightly albeit remaining strong. This is good news for a continuation of the global profit recovery going forward, with profits needed to take over as a key driver of the bull market in shares as shares are no longer dirt cheap or under loved.

Eurozone break up risks continued to remain a focus over the last week with: the risks easing a little around the French election (as the prospects of combined Socialist/far left presidential bid receded, an investigation around Le Pen's use of European Union funds hotted up and centre-left candidate Macron and another centrist candidate agreed to work together); Greece edging towards a deal with the IMF and EU on its latest bailout review; but the risks around a break-up of the governing Democratic Party in Italy remaining. There is a long way to go on the Eurozone break up risk soap opera, so lots could go wrong (including more rioting in French suburbs boosting support for Le Pen), but a break up still seems far from imminent so spikes in fears around Europe should be seen as buying opportunities. Particularly with Eurozone shares still clearly cheap and underlying economic conditions in Europe looking good.

On the interest rate front in Australia, a speech and Parliamentary testimony by RBA Governor Philip Lowe has reiterated that the RBA is trying to balance the risks of inflation staying lower for longer versus the threat to financial stability that may flow from ever higher household debt if the RBA cuts rates again. Governor Lowe is clearly happy with another “period of stability” in rates and, in other words, is prepared to run a higher risk in terms of inflation remaining lower for longer to head off the risk of higher household debt. Fair enough. As this points to a relatively high hurdle to cutting rates again – e.g., worsening unemployment or a further leg down in inflation – the risk that we may not get the rate cut we have been looking for is high.

Two reasons why allowing first home buyers in Australia to access their super to buy a house is a really dumb idea. First, any boost in their home buying power will just be reflected in even higher home prices (as with first home buyer grants and lower interest rates). Second, it will mean they have less money for retirement as their lower super balances in the early years of their working lives will mean less for compound interest to work its magic on. So even less affordable housing and less in retirement. This idea gets floated every few years but its best forgotten.

Major global economic events and implications

The key message from the minutes from the Fed's last meeting was that the Fed is on track to raise interest rates again "fairly soon", providing economic data is in line with or better than their expectations. Of course, the term "fairly soon" is a bit vague and could mean any of its March, May or June meetings. Since the last Fed meeting though, strong payrolls data and CPI inflation suggest a risk of a March move but slow wages growth and a desire to remain consistent with three hikes this year point to a move around May or June. This is our base case but we see a 40% chance of a March hike. Meanwhile, data over the last week added nothing new with business conditions PMIs falling slightly in February but remaining strong, home sales rising strongly, home prices continuing to rise, consumer sentiment remaining strong and jobless claims remaining low.

Eurozone business conditions PMIs - both manufacturing and services - improved further in February pointing to acceleration in growth. For now, the ECB is committed to quantitative easing through to the end of the year at the rate of €60bn a month, but debate about when it will announce a taper will likely to continue to hot up. Nothing is likely to be announced until later this year though, at least not until after the French election is out of the way.

Japan's manufacturing conditions PMI also improved further in February continuing a recovery since May last year and pointing to stronger growth ahead.

Australian economic events and implications

The news on the Australian economy over the last week was, on balance, a little bit disappointing with wages growth remaining at a record low and investment coming in weaker than expected. Low wages growth adds to the risk that inflation will stay lower for longer and soft business investment data will constrain the expected rebound in December quarter GDP growth after the September quarter contraction. However, while investment plans for the financial year ahead are yet again below those of a year ago, the rate of decline has slowed (see the next chart) and it's all driven by mining investment (which is falling at the rate of around 30% pa) whereas plans for non-mining investment are about 7% stronger than was the case a year ago. What's more, the drag on overall growth in the economy from the mining investment slump is diminishing as it’s now a much smaller share of the economy and in any case it's getting back to levels that are close to as low as it ever goes.

 

Source: ABS, AMP Capital 

Cuts to penalty rates – good or bad? The Fair Work Commission’s decision to cut Sunday and public holiday penalty rates by 25% or so has created much contention. But it basically comes down to a trade-off between wages for those in relevant industries with jobs and the 1.8 million people without jobs, or who are underemployed. Yes, it will cut wage income for those affected and will weigh further on average wages growth, but against this, the decision partly reflects the fact that Sunday’s and public holidays are no longer sacrosanct like they used to be and it will make it possible for employers to employ more people or have them for longer hours (unless you believe that demand for something goes down when its price goes down). So, the decision is no disaster for the economy and, if anything, by injecting a bit more flexibility into the labour market it will help boost productivity and employment. It also maintains the hope that Australia can still get through a bit of economic reform, despite the scare campaign around any proposed economic reforms that dominates the media 24/7 now. 

The Australian December-half profit reporting season is now just over 90% done. Results remain consistent with a strong return to profit growth, but as always, we have seen more soft results as the reporting season has progressed. 46% of companies have exceeded earnings expectations compared to a norm of 44%, 59% of companies have seen profits up from a year ago and 59% have increased their dividends from a year ago. But reflecting the strong rally in the market ahead of the results, only 50% of companies have seen their share price outperform the market on the day they reported as a lot of good news was already priced in. Consensus profit expectations for the overall market for this financial year have been revised up by around 2% through the reporting season to a strong 19%. This upgrade has all been driven by resources companies which are on track for a rise in profit of 150% this financial year, reflecting the benefits of higher commodity prices and volumes on a tighter cost base. Profit growth across the rest of the market is likely to be around 5%, with mixed bank results and constrained revenue growth for industrials. Outlook comments have generally been positive, and as a result, the proportion of companies seeing earnings upgrades has been greater than normal. The focus has remained on dividends with 79% raising or maintaining their dividends.

 

Source: AMP Capital

Source: AMP Capital

Source: AMP Capital

What to watch over the next week?

In the US, President Trump’s address to Congress on Tuesday will be watched for details around his plans for tax cuts, infrastructure spending, etc. The focus will also be on the February ISM manufacturing index (Wednesday) and non-manufacturing conditions index (Friday) both of which are likely to remain strong. Speeches by Fed Chair Yellen and Vice-Chair Fischer (Friday) will be watched for clues as to whether to expect faster Fed rate hikes. Meanwhile, expect underlying durable goods orders to show further improvement and a rise in pending home sales (both Monday), a slight upwards revision to December quarter GDP growth to 2.1% annualised and continued strength in home prices and consumer confidence (all Tuesday), and a rise in inflation as measured by the core private final consumption deflator (Wednesday) to 1.8% year on year from 1.7% year on year. 

In the Eurozone, expect economic confidence indicators for February (Monday) to have remained strong, CPI inflation to edge a bit higher but core inflation to have remained around 0.9% yoy and unemployment (Thursday) to have fallen to 9.5%.

In Japan, expect a slight pull back in January industrial production (Monday), but continued strength in labour market indicators and a slight further improvement in household spending (Friday). Core inflation (also Friday) is likely to have remained around zero. 

Chinese manufacturing conditions PMIs for February (Wednesday) are expected to have remained around 51.

In Australia, December quarter GDP data is likely to show a bounce back in growth led by a stronger consumer, a rebound in dwelling investment and public spending, better trade volumes and bit less negative business investment. However, it looks likely to be only around 0.6% quarter on quarter, leaving annual growth at just 1.8% year on year. Ahead of the GDP release, expect a strong rise in December quarter company profits led by the mining sector (Monday) and net exports (Tuesday) to contribute 0.2 percentage points to GDP growth. Meanwhile expect continued momentum in February home prices (Wednesday), another big trade surplus (Thursday) and a small fall in building approvals (Thursday). 

The Australian December-half profit reporting season will wrap up on Monday and Tuesday with only 15 major companies left to report including QBE and Lend Lease. 

Outlook for markets

Shares remain vulnerable to a pull back as short term investor sentiment towards them is very bullish, Trump related uncertainty will be with us for a while and various European elections could create nervousness in coming months. However, we see share markets trending higher over the next 12 months helped by okay valuations, continuing easy global monetary conditions, fiscal stimulus in the US, some acceleration in global growth and rising profits.

Still low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds. Australian bonds are preferred to global bonds reflecting higher yields and as the RBA is well behind the Fed in raising rates. 

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

National residential property price gains are expected to slow to around 3-4% this year, as the heat comes out of Sydney and Melbourne and rising apartment supply hits. 

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

The $A has had a short term bounce as the $US corrected from overbought levels. This could go further and see a retest of $US0.78 which if broken would likely see a run up to $US0.80. However, the downtrend in the $A from 2011 is likely to resume at some point this year as the interest rate differential in favour of Australia narrows and it undertakes its usual undershoot of fair value. 

While Eurozone shares fell 0.9% on Friday, the US S&P 500 saw a late rally that pushed it up 0.1% perhaps in anticipation of President Trump’s address to Congress this coming Tuesday. Despite the basically flat US lead, ASX 200 futures fell 0.3%, pointing to a 16 point fall at the open for Australian shares on Monday.

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Eurozone risks to present buying opportunities

Monday, February 20, 2017

By Shane Oliver

Most major share markets continued to move higher over the past week, helped by more good economic and profit news and anticipation of President Trump’s pro-business policies. US shares gained 1.5%, Eurozone shares rose 1%, Chinese shares rose 0.2% and Australian shares gained 1.5%, but Japanese shares fell 0.7%. Bond yields generally rose as the reflation trade continued but commodity prices were mixed, with oil and metal prices down a bit but the iron ore price surging higher. The $A was little changed.

The resignation of President Trump’s National Security Adviser Mike Flynn and the ongoing investigations into links between Trump’s campaign and Russia highlights the political risks around this unusual administration. But as long as Trump continues on the path to implementing his pro-business agenda (and assuming Trump himself is not implicated) it’s just ongoing noise that investors have to get used to.

The focus on Eurozone breakup risk is continuing to hot up, with elections approaching in the Netherlands on March 15, France in late April/May and Germany in September. Our view remains that such risks are overstated, but any related market panic should provide an opportunity for investors. Looking at each in turn, based on current polling:

  • The populist Eurosceptic Party for Freedom will get more than any other party in the Dutch parliamentary elections but at around 20% of the vote and seats won’t be able to form government, with that likely to come from some combination of roughly ten centrist parties. 
  • Similarly, Marine Le Pen, whose policy is to leave the Eurozone, will “win” the first round of the French presidential election with around 25-30% of the vote but will most likely lose the second round to either the Republican Party’s Francois Fillon (by 15-20%) or more likely to the independent Emmanuel Macron (by 20-30%). Both Fillon and Macron are economic reformists which is exactly what France needs. The main risk is that the Socialist candidate, Benoit Hamon, manages to form a joint ticket with more leftist Jean-Luc Melenchon and the Green Party’s Yannick Jadot (which is a big ask given the differences between them) and then make it through to the second round against Le Pen where she would have a greater chance of defeating them.  
  • The German election is a long way away, but German Chancellor Angela Merkel is at some risk of losing to the centre-left Social Democrat Party whose new leader Martin Schulz is polling well. But Schulz is more pro Europe than Merkel, so even if he does win, it could actually mean a stronger Eurozone as he and the SPD are likely to end austerity in favour of some German fiscal reflation (which could help both Germany and peripheral Eurozone countries). The populist Alternative for Deutschland seems stuck at around 10% support. 
  • Ahhh, you say – but what about Brexit and Trump? Surely there is a risk of a populist upset? Yes there is – particularly in the Netherlands or France. But the polling against a populist forming government in these three countries is more decisive than was the case prior to the Brexit vote and US presidential election (where the polling was actually very close). More fundamentally, it can be argued that Europe is different. Support for the Euro remains high at around 70% and inequality is far less of an issue in most of Europe than in the UK or the US. And an abatement of the migration crisis is helping too. 
  • Perhaps the country at greatest risk is Italy, particularly with the governing Democratic Party showing signs of breaking up, but even here, if the Eurosceptic Five State Movement wins in their next election (possibly this year), it is likely to end up going down the path of Greece’s Syriza which has become just another European centrist party after it realised the cost to Greece of exiting the Euro. Speaking of which, Greece is at risk again facing tough negotiations with its creditors. These will probably be resolved but even if not and an early election ensues it’s noteworthy that the pro-Euro, pro-reform New Democracy party is polling well.
  • The bottom line is that Eurozone break up risks are overstated and if they intensify in the months ahead hitting Eurozone shares, bonds and other assets, it should be seen as a buying opportunity.

Major global economic events and implications

  • US economic data continues on the strong side, with a solid gain in retail sales, small business confidence remaining strong, very strong readings in the New York and Philadelphia regional manufacturing conditions surveys, continued strength in home builder conditions, strong readings for housing starts and permits and continuing ultra-low unemployment claims. Meanwhile, core consumer price inflation edged up more than expected to 2.3% year on year. Fed Chair Janet Yellen’s Congressional testimony on the rates front provided nothing new, signalling an intention to make haste gradually in raising rates this year and that all coming meetings are live for the next move providing the data behaves as expected. Our base case remains that the next hike will be in May or June, but the past week’s run of strong data points to a rising risk of a March hike (with the market currently putting the probability of such a move at 36%.) 82% of US S&P 500 companies have now reported December quarter profits, with 74% beating earnings expectations with an average surprise of +2.7% and 52% beating on revenue.
  • Japanese December quarter GDP growth disappointed at 0.2% quarter on quarter, or 1.6% year on year. But it marked four straight quarters of positive growth and business conditions indicators point to some acceleration ahead.
  • Chinese consumer and producer price inflation rose more than expected in January and combined with a surged in credit underpin the PBOC’s move to gradually tighten monetary policy. While a range of infrastructure projects should support growth in the near term and the Chinese Government unlikely to allow growth to slow much, the move to policy tightening and threat to growth will no doubt worry investors at some point later this year.

Australian economic events and implications

  • Australian economic data was good, with a further gain in business conditions and confidence in January according to the NAB survey, a rise in consumer confidence to around its long term average, stronger than expected jobs growth in January and a fall in unemployment. The main drag was a return to weakness in full time jobs, highlighting that the quality of jobs growth remains poor. This is partly structural reflecting the growing importance of the services sector in the economy and its preponderance towards part time jobs but it’s also partly cyclical and on this front it’s worth noting that job vacancies and business employment plans point to stronger employment growth ahead, which should help full time jobs.
  • Another big positive is the ongoing rise in the iron ore price which broke $US90/tonne in the last week for the first time since 2014. Softer structural growth in China and stronger supply warn this is not the start of a re-run of last decade’s commodity boom. But it's nevertheless a big positive for national income in Australia. The iron ore price at $US90, if sustained, will add around $9bn annually to Federal taxation revenue.

Source: Bloomberg, AMP Capital

  • At this stage our view remains that the RBA will cut rates again this year as inflation takes longer to move back to target. But if the positive news on growth and national income continues at a time when the Sydney and Melbourne property markets remain too hot then we will have to concede that the next move in rates is up – albeit not till later in 2018 – rather than down.
  • We are now a bit over 40% through the Australian December half profit reporting season. As is often the case after an initial flurry of good results, we have seen a few more misses over the last week. But so far the overall results remain good. 53% of companies to report so far have exceeded earnings expectations compared to a norm of 44%, 70% of companies have seen profits up from a year ago and 69% have increased their dividends from a year ago. But reflecting the strong rally in the market in anticipation of the results, only 44% have seen their share price outperform the market on the day they reported as a lot of good news was already priced in. Resource profits are on track to more than double this financial year and this is driving a return to overall profit growth for the market.

Source: AMP Capital

Source: AMP Capital

Source: AMP Capital

What to watch over the next week?

  • In the US, expect business conditions PMIs for February (Tuesday) to remain strong and consistent with solid growth, a bounce back in existing home sales (Wednesday) and new home sales (Friday) and continued strength in house prices (Thursday). The minutes from the Fed's last meeting (Wednesday) are likely to confirm that the Fed sees itself as being on track to continue gradually raise interest rates.
  • In the Eurozone, business conditions PMIs for February (Tuesday) are also expected to remain strong, consistent with a pick-up in Eurozone economic growth.
  • Japan's manufacturing conditions PMI (Tuesday) is likely to show a further improvement.
  • Chinese property price data for January (Wednesday) is expected to show some further slowing in growth as property cooling measures continue to bite.
  • In Australia, expect the minutes from the last RBA Board meeting (Tuesday), a speech by RBA Governor Lowe (Wednesday) and his parliamentary testimony (Friday) to confirm that the RBA is comfortably on hold for now. On the data front, expect to see December quarter wages growth (Wednesday) remain at a record low of 1.9% year on year, December quarter construction data (also Wednesday) to show a 1% quarter on quarter bounce back after bad weather and a few other things affected the September quarter, but with mining construction still falling and December quarter business investment (Thursday) to also show a 1% quarter on quarter gain. Of most interest in the capex data will be investment intentions for this financial year and next which are expected to foreshadow some improvement in non-mining investment.\
  • The Australian December half profit reporting season will hit is biggest week with nearly 100 major companies reporting, including Worley Parsons, BHP, IAG, Woolworths and Qantas. Resource company profits are on track to more than double, but profit growth across the rest of the market is likely to be around 5%. Key themes are likely to be: a massive turnaround for resources companies; constrained revenue growth for banks and industrials; and an ongoing focus on dividends. 

Outlook for markets

  • Shares remain vulnerable to a short term pull back as sentiment towards them remains very high, Trump related uncertainty will be with us for a while and various European elections could create nervousness in coming months. However, we see share markets trending higher over the next 12 months helped by okay valuations, continuing easy global monetary conditions, fiscal stimulus in the US, some acceleration in global growth and rising profits.
  • Still low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds. Australian bonds are preferred to global bonds reflecting higher yields and as the RBA is well behind the Fed in raising rates. 
  • Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this demand will wane as bond yields trend higher over the medium term. 
  • National residential property price gains are expected to slow to around 3-4% this year, as the heat comes out of the Sydney and Melbourne and rising apartment supply hits. 
  • Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.
  • The $A has had a short term bounce as the $US corrected from overbought levels. This could go further and see a retest of $US0.78 which, if broken, would likely see a run up to $US0.80. However, the downtrend in the $A from 2011 is likely to resume at some point this year as the interest rate differential in favour of Australia narrows and it undertakes its usual undershoot of fair value. Expect a fall below $US0.70 by year end.
  • Eurozone shares fell 0.2% on Friday as worries around the French election impacted, but the US S&P 500 rose 0.2%. Reflecting the positive US lead, ASX 200 futures rose 0.1% pointing to a modest five point gain at the open for the Australian share market on Monday.
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Trump's pro-growth agenda alive and well

Monday, February 13, 2017

By Shane Oliver

Most major share markets rose over the last week, helped by a combination of good economic data and profit news and announcements from President Trump progressing his deregulation and tax reform agenda. US shares rose 0.8%, Japanese shares rose 2.4%, Chinese shares gained 1.5% and Australian shares rose 1.8%. Eurozone shares slipped 0.1%. Bond yields mostly fell, though helped along by dovish comments from ECB President Draghi. Oil prices were flat but metal prices were up and the iron ore price rose to its highest since 2014. The $A rose slightly, despite a stronger $US.

The message from the first few weeks of Trump’s presidency is that, while he is generating a lot of noise, as long as he makes periodic announcements progressing his pro-growth policies – rolling back Dodd-Frank, working towards a “phenomenal” tax plan, making “life good” for airlines, etc – then share markets will respond positively. So, while all the noise around the travel ban, whether the Lindt Café siege was “underreported” (I was in Memphis on an Elvis pilgrimage at the time and the siege had plenty of coverage on US TV!), etc., is interesting, investors should turn down all this noise when making investment decisions. 

Adding to the positive tone were signs that Trump is taking a less antagonistic approach to China and Japan on trade, with Trump agreeing to respect the “One China” policy and reporting to have said he wants a “constructive relationship” and “mutual benefits” with China, and Trump and Japan PM, Abe, agreeing to start new trade and investment talks. 

While unwinding the Dodd-Frank financial regulations will take time and face constraints (as it will likely require the support of eight Democrat Senators, although it may be possible to find work-arounds), tax reform is likely to proceed more quickly as Congress has already done significant work on it and it can pass through the Senate using budget reconciliation rules that only require a simple Senate majority – which the GOP has.

It now looks likely that the Trump administration will submit a tax plan to Congress in a few weeks – this is almost certain to include a cut in the corporate tax rate (to 20% or so) and possibly also a cut to personal income tax rates. It’s less clear whether a “border adjustment tax” (rebating tax on exports and taxing imports) will be included. Taking the US corporate tax rate from 35% to 20% will put massive pressure on Australia at 30% and other countries to follow suit (the OECD average is around 25%).

In Australia, the Reserve Bank left interest rates on hold as expected, but in its Statement on Monetary Policy, made little significant changes to its growth and inflation outlook – seeing December quarter GDP growth rebound, growth averaging around 3% over the next few years and inflation heading back to 2% by the year's end. The Bank’s post-meeting statement, a speech by Governor Philip Lowe and the Statement on Monetary Policy, all presented a relatively upbeat assessment on the economic outlook. While we have a similar growth outlook, our view remains that it will take longer for inflation to return to target than the RBA is allowing, particularly with wages growth at record lows and the $A trending higher. As a result, we remain of the view that the RBA will likely cut rates again this year, probably in May after the next round of inflation data. Given the improving global growth and inflation outlook though and the desire to avoid adding to financial stability risks, our call for another RBA rate cut is a close one. 

Surprisingly, the RBA’s level of concern around the property market does not appear to have increased despite a further pick up in lending to property investors and rapid price growth in Sydney and Melbourne. This appears to partly reflect the RBA’s assessment that lending standards have tightened, the supply of property is set to rise with longer-than-normal lags and that part of the recent upswing in investor credit may reflect investors paying for properties bought off the plan some time ago. There still remains a case for a precautionary lowering in APRA’s 10% investor credit growth limit though.

Major global economic events and implications

US job openings and quits remained basically unchanged at relatively high levels, jobless claims fell to ultra-low levels and the trade deficit narrowed slightly in December. 72% of US S&P 500 companies have now reported December quarter profits, with 75% beating earnings expectations with an average surprise of +3.6% and 51% beating on revenue. Earnings are now expected to be up 6.3% from a year ago. 

Japanese data showed a slight fall in confidence and continuing weak wages growth but improved machinery orders, a rise in Japan’s leading index and an ongoing decline in bankruptcies and the first annual rise in producer prices since March 2015.

Chinese foreign reserves fell below $US3 trillion for the first time since 2011 as China continues to see capital outflows and is using its reserves to slow the decline in the Renminbi (are you listening President Trump?). Meanwhile, Chinese imports and exports rose much more than expected in December, which fits with stronger Chinese and global demand but may also reflect seasonal Lunar New Year distortions.

Australian economic events and implications

It's too early to read much into the December-half profit reporting season because less than 20 major companies have reported to date. But so far so good, with 67% exceeding earnings expectations compared to a norm of 44%, 67% of companies seeing profits up from a year ago and a stronger-than-expected result from Rio Tinto confirming that the turnaround in resources sector profits is on track. 

Source: AMP Capital

Source: AMP Capital

On the data front in Australia, December quarter retail sales volumes rebounded 0.9%, adding to confidence that consumer spending and hence GDP growth rebounded in the December quarter. While retail sales unexpectedly fell 0.1% in the month of December, this reflected a sharp fall in hardware, building and garden supplies (possibly reflecting the wind down of Masters) so is unlikely to mean much. Meanwhile, new home sales were flat in December according to the HIA but still appear to be tracing out a gradual downtrend since their high in 2015 and December housing finance commitments saw a slight swing back in favour of owner occupiers - but not much.

What to watch over the next week?

In the US, the focus is likely to remain on the noise coming out of Washington but also on Fed Chair Janet Yellen's Congressional testimony (on Tuesday and Wednesday) which is likely to repeat the message from the Fed's last meeting that it remains on track to hike further this year, but that the process is likely to be gradual. Her response to questions regarding the impact of the new president will no doubt be watched closely, but the Fed is basically in wait-and-see mode on that front. Expect headline CPI inflation (Wednesday) to have increased further to 2.4% year on year (yoy) in January, but core inflation to fall slightly to 2.1% yoy, solid growth in underlying retail sales in January, flat industrial production, continuing strength in the home builders' conditions index (all Wednesday) and flat housing starts (Thursday). December quarter earnings results will continue to flow.

Japanese December quarter GDP data (Tuesday) is expected to show growth at 0.3% quarter on quarter (qoq) or 1.8% yoy.

Chinese inflation data for January (Tuesday) is likely to show a further rise in CPI inflation to around 2.3% yoy and a further uplift in producer price inflation to 6.5% yoy as the slump in commodity prices a year ago continues to drop out.

In Australia, expect continued strength in business conditions according to the NAB's January survey, a bounce in consumer confidence (Wednesday) and January jobs data to show a 10,000 gain in employment but unemployment holding at 5.8%.

The Australian December half-profit reporting season will ramp up further with 61 major companies reporting (including JB HiFi, CBA, Wesfarmers, Origin and Telstra). Earnings upgrades for resources stocks on the back of the rise in commodity prices has seen the consensus expectation for 2016-17 earnings growth rise to 17%. Resource company profits are expected to more than double, but profit growth across the rest of the market is likely to be around 5%. Key themes are likely to be: a massive turnaround for resources companies, constrained revenue growth for banks and industrials, and an ongoing focus on dividends. 

Outlook for markets

Shares remain vulnerable to a short-term pullback as sentiment towards them remains very high, Trump-related uncertainty will be with us for a while, and various European elections could create nervousness in coming months. However, we see share markets trending higher over the next 12 months helped by okay valuations, continuing easy global monetary conditions, fiscal stimulus in the US, some acceleration in global growth and rising profits.

Still low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds. Australian bonds are preferred to global bonds reflecting higher yields and as the RBA is well behind the Fed in raising rates. 

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

National residential property price gains are expected to slow to around 3-4% this year, as the heat comes out of the Sydney and Melbourne and rising apartment supply hits. 

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

The $A has had a short-term bounce as the $US corrected from overbought levels. This could go further and see a retest of $US0.78. However, the downtrend in the $A from 2011 is likely to resume as the interest rate differential in favour of Australia narrows and it undertakes its usual undershoot of fair value. Expect a fall below $US0.70 by year end.

Eurozone shares were flat on Friday and the US S&P 500 rose 0.4% to a new record high. Reflecting the positive lead from US shares along with rising prices for oil, metals and iron ore ASX 200 futures rose 0.2%, pointing to a 10 point gain at the open for the Australian share market on Monday.

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A constrained year for investors

Fed on track to hike

Market focus on central banks

Share markets bounce back

Santa Claus rally likely

Solid gains for global shares

What to watch over the next week

The ECB signals further monetary easing

Pressure mounts on the RBA

The great rebound

US Congress showdown to grip markets

US rate hike expectations shift to 2016

Rough ride ahead

Falling dollar to provide boost for economy

From goodbye to good buy

Is this 1997-98 all over again?

Reporting season so far

Cost cutting focus of earnings reports

The week in review and what's ahead

Global focus returns to the US

Is the short-term correction over?

Uncertain times

Volatility to continue, but bull market not over yet

The RBA's clear easing bias is back

Greek negotiations drag on

RBA not expected to cut...yet

US GDP and Eurozone confidence

What's happening at the Fed?

The lessons of the last Budget

What to watch over the next week

The Fed is the focus

A full week of US earnings results

What to watch over the next week

What to watch over the next week?

The economic week ahead

All eyes on the Fed

Shares at risk of a correction

What to watch over the next week

What to watch over the next week?

Earnings numbers and the week ahead

What to watch over the next week?

What to watch over the next week

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