2 June 2017
Share markets rose over the last week helped by mostly good economic data and expectations central banks will remain benign. US shares rose 1% to a new record high, Eurozone shares gained 0.5%, Japanese shares surged 2.5%, Chinese shares rose 0.2% and Australian shares gained 0.6%. While bond yields rose in Italy on early election fears, they were flat in Australia and Japan and fell in core Europe and the US after softer than expected US jobs data. Commodity prices mostly fell but a weaker US$ resulted in little change in the A$.
Are things so bad equity managers should hand all their funds back to their clients as one Australian manager is reported to have done? Putting aside speculation around other issues that may have driven the decision there are several points to make in relation to this. First, shares globally are at risk of a correction but the combination of improved growth including solid business conditions (see the next chart), rising profits, okay valuations and low interest rates indicates the broad backdrop is reasonable.
Source: Bloomberg, AMP Capital
Second, risks remain around China but they have long been there and there is no indication it’s suddenly about to fall over. Similarly, I am expecting a pullback in Sydney and Melbourne property prices and the Australian economy remains weak but it’s doubtful that it’s on the edge of the abyss. Fourthly, over the years there have been numerous high profile calls to “sell everything” or “gear up big time for the great boom ahead”. Some get lucky but many not, the point being that it’s dangerous to bet everything on one big call. Finally, individual fund managers are usually chosen to fill a role in a portfolio of assets which has been carefully constructed to meet investment goals over time with the expectation that each fund manager will manage the assets in their care in line with their process and views. So if one manager decides to give the money back, the manager of the whole portfolio – be that a financial planner, super fund or individual – will invariably just have to find another manager to fill the gap.
President Trump’s decision to leave the Paris climate agreement will have little short term impact on markets but poses a longer term negative for the US (and for global warming). Short term it’s of little consequence for investment markets. It will take time for the US to exit and several key US states (notably California) will uphold the Paris agreement and more anyway. Longer term it’s another delay in doing something about climate change and the US will pay some price as the rest of the world pushes faster towards renewables leaving the US behind. Of course, the next US President will likely sign up again but the delay is not helpful.
Just when it seemed “Eurozone break up risks” would be quiet for a while there is renewed talk of an early Italian election. Their next election is due by May next year but signs of agreement on electoral reform and a desire on the part of the governing Democratic Party (PD) to get an election out of the way before a contractionary budget due later this year have raised again the prospect of an early election around September-October. With the populist mostly anti-Euro Five Star Movement (5SM) tied in the polls with the PD, there is a good chance that it will win the most seats. However, it’s doubtful 5SM will be able to agree a coalition with the right wing Eurosceptic Northern League (which at times has advocated a break up of Italy). In which case Italy will revert to a coalition involving the current government and the idea of Italy leaving the Euro will recede again. None of this will stop markets from worrying about it in the interim. But one thing that helps fade the risk of a Eurozone break up though is that the elections in Europe since the Brexit vote have seen the rejection of anti-Euro parties suggesting the risk of Italy setting off a domino effect across Europe of countries seeking to leave the Euro is low. As such we remain upbeat on Eurozone shares.
Major global economic events and implications
US data was mostly good with a solid May manufacturing conditions ISM, consumer confidence down a bit but still very strong, solid gains in personal income and spending in April and continued increases in home prices. US jobs data was mixed though with payrolls up by a less than expected 138,000 in May, but with unemployment falling to 4.3%, underemployment falling to near pre GFC lows, jobless claims at early 1970s levels and other job indicators remaining robust it’s hard to conclude that the US jobs market is anything other than strong. As a result, the Fed remains on track to hike rates again this month. However, the lack of any significant acceleration in wages growth (it was just 2.5% year on year in May) along with core private consumption deflator inflation falling to 1.5% year on year in April will keep the Fed gradual and it may even lower it’s so called “dot plot” of rate hike expectations for next year.
Eurozone core inflation also fell in May, back to 0.9% yoy, which explains why, despite stronger activity data including another decline in unemployment and strong confidence readings, ECB President Draghi remains dovish.
Japanese data remained mixed with strong labour market data, industrial production and a rise in the manufacturing conditions PMI but weak household spending. Depressed wages growth remains an ongoing constraint.
Chinese business conditions PMIs were confusing in May with stronger services conditions, a flat official manufacturing PMI but a further decline in the Caixin manufacturing conditions PMI. Averaging them out suggests stable growth after the slowdown of the last few months.
Australian economic events and implications
Australian data over the last week was messy. Building approvals bounced but the trend remains clearly down. Retail sales bounced in April allaying fears for now of a consumer collapse and setting up a stronger June quarter, but the bounce looks partly due to better weather and the timing of Easter and the consumer remains under some pressure. Business investment was flat in the March quarter, mining investment looks like it’s getting close to the bottom and investment plans point to a slowing in the pace of decline in business investment but it’s still falling (see the next chart).
Source: ABS, AMP Capital
Our estimate for March quarter GDP growth remains 0.1%, but given normal forecasting errors a negative outcome is a very high risk. With consumers under pressure and the impact of Cyclone Debbie on coal exports risking a negative June quarter there is a possibility of a technical recession. Of course solid forward looking jobs indicators, a slowing drag from falling mining investment and strong public capital spending all argue against getting too gloomy, but the overall picture is one of sub-par growth running well below that assumed by the RBA and in the Budget. In our view this all points to the rising risk of another interest rate cut, a continuation of the relative underperformance of Australian shares compared to global shares that started in 2009 and a break in the value of the A$ below US$0.70.
On the house price front, CoreLogic data for May adds to evidence that the peak at least in terms of momentum has been seen. The drip feed of negative news regarding the Sydney and Melbourne property markets – bank rate hikes, APRA moves, surging unit supply, tightening conditions for investors and foreign buyers (with NSW moving again on foreign buyers in the last week), constant warnings of a bubble about to burst – is starting to impact. Overall our view remains that the peak in home price growth in Sydney and Melbourne has been seen and that further weakness lies ahead with ultimately a 5 to 10% average decline and that unit prices in parts of Sydney and Melbourne will fall by 15-20%. In the absence of much higher interest rates, much higher unemployment and a generalised oversupply a property crash (say a 20% plus fall in average home prices is unlikely). Of course it’s dangerous to generalise across Australia – Perth property prices are probably getting close to the bottom and Brisbane and Adelaide prices are likely to continue meandering along at around 3% year on year.
What to watch over the next week?
In the US, expect the non-manufacturing conditions ISM (Monday) to remain strong at around 57 and job openings and hiring (Tuesday) to remain solid.
The European Central Bank (Thursday) is expected to leave monetary policy on hold. While it may move to characterise the risks around its forecasts as being balanced reflecting recent strong economic activity related indicators President Draghi is likely to remain dovish and stress the need for ongoing monetary support given the lack of upwards pressure on underlying inflation. Political uncertainty around Italy will also help keep the ECB dovish.
The UK election (Thursday) has turned into a more interesting affair with the Government’s poll lead declining. The most likely scenario remains that the Tories are returned with some increase in seats which would have little bearing on Brexit. Alternatively if Labour wins Brexit may turn out to be softer, but expect to see a return to a pre Thatcher world of far great government involvement in the economy which will not augur well for productivity (oddly at a time when the French are going in the opposite direction). Either way there are likely to be minimal implications for the global economy or Europe which since the Brexit vote has moved against populism.
Chinese trade data (Thursday) is likely to show export growth slowing to 7% year on year and import growth slowing to 9%. CPI inflation (Friday) is likely to have risen to 1.4% yoy, but producer price inflation is likely to slow to 5.5%.
In Australia, the RBA is likely to leave interest rates on hold for the tenth month in a row at Tuesday’s board meeting as only a month has passed since it expressed more confidence around the outlook for growth and inflation. The RBA will likely also conclude that it’s way too early to declare victory in its efforts to slow the Sydney and Melbourne property markets and recent strength in employment and business surveys also support the case to remain on hold for now. However, the chance of another rate cut by year end is steadily rising – growth looks like it will come in well below the RBA’s forecasts thanks to weak consumer spending and business investment along with slowing housing investment and subpar growth and record low wages growth is likely to keep inflation lower for longer too. In the meantime, the softening in the Sydney and Melbourne property markets will provide flexibility for the RBA to cut again if needed. The money market’s implied probability of a 20% chance of a rate cut by year end is way too low – it should probably be around 45%.
On the data front in Australia, the focus is likely to be on March quarter GDP data to be released Wednesday which is expected to show growth faltering again to just 0.1% quarter on quarter or 1.5% year on year thanks to a combination of weak consumer spending, a fall in housing investment and a detraction to growth from trade. However, data on profits and inventories (Monday) and public demand and net exports (Tuesday) will help firm up GDP forecasts and on this front net exports are expected to be weak but public demand growth should be positive. The trade surplus for April (Thursday) is likely to show a sharp decline thanks to the impact of Cyclone Debbie on coal exports but this should reverse in May. Housing finance data for April (Friday) is likely to show a further decline.
Outlook for markets
Shares remain vulnerable to a short term setback as we are now in a weaker seasonal period for shares with risks around President Trump, North Korea, Chinese growth and the Fed’s next rate hike providing potential triggers. However, with valuations remaining okay – particularly outside of the US, global monetary conditions remaining easy and profits improving on the back of stronger global growth, we continue to see any pullback in shares as an opportunity to “buy the dips”. Shares are likely to trend higher on a 6-12 month horizon.
Low yields and capital losses from a gradual rise in bond yields are likely to see low returns from sovereign bonds.
Unlisted commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this demand will wane eventually as bond yields trend higher.
National residential property price gains are expected to slow, as the heat comes out of Sydney and Melbourne.
Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.
For the past year the A$ has been range bound between US$0.72 and US$0.78, but our view remains that the downtrend in the A$ from 2011 will resume this year. The rebound in the A$ from the low early last year of near US$0.68 has lacked upside momentum, the interest rate differential in favour of Australia is continuing to narrow and will likely reach zero early next year (as the Fed hikes rates and the RBA holds or cuts) and commodity prices will also act as a drag (particularly the plunge in the iron ore price). Expect a fall below US$0.70 by year end.