(18 November 2016)
The past week saw US shares gain 0.8% and Japanese shares gain 3.4% as bond yields and the US$ continued to push higher as investors focussed on prospects for fiscal stimulus and deregulation under a Donald Trump presidency. However, Chinese shares were flat, Eurozone shares slipped 0.1% and Australian shares fell 0.2% after their 3.7% surge in the previous week. Emerging market shares remained under pressure from the rising US$ and commodity prices were mixed. The rising US$ saw the A$ fall below $US0.74 which is good news for the Reserve Bank of Australia (RBA).
It’s still early days but the past week provided a bit more evidence that we are more likely to see a pragmatic Donald Trump as president (focussed more on positive measures to boost growth – tax cuts, infrastructure spending and deregulation) rather than a protectionist populist. To be sure some of the appointments to his team have raised question marks and some action on the trade front looks inevitable but his appointment of a Republican establishment figure as his Chief of Staff and his watering down of commitments around the Affordable Care Act, the wall with Mexico and deporting illegal immigrants suggest he is likely to be more moderate than his campaign rhetoric suggested. As such, while risks on the trade front are high we remain of the view that his stimulatory policies on balance are likely to be neutral to positive for advanced country equities, positive for commodities, positive for the US$ as the Fed is likely to tighten by more, and negative for bonds and some emerging share markets (as a rising US$ creates dollar funding concerns). Of particular note though:
- The last two big cyclical surges in the US$ in 1981-85 and 1997-2001 were actually good for US shares with the S&P 500 Index up 50% and 80% in each period respectively.
- European and Japanese equities will be particular beneficiaries of a rising US$– maybe not so much Europe in the short term, given short term risks around Italy and Austria (see below), but particularly Japanese shares which get the benefit of a falling Yen but are not seeing the same upward pressure on bond yields because of the Bank of Japan’s commitment to cap Japanese government bond yields at zero which in turn is amplifying downward pressure on the Yen.
- Upward pressure on bond yields (made worse by an unwinding of long bond positions) and the US$ is likely to pause and then become more gradual as the rise in the US$ at a time when other central banks are a long way from tightening will help limit how quickly the Fed will raise rates.
- The falling Chinese Renminbi (RMB) is a strong US$, not weak Renminbi story.Over the last week, as the US$ Index (DXY) rose 2.3% against a basket of currencies, the RMB fell 1.2% against the US$ but its trade weighted basket is basically flat. In fact, the fall in the RMB against the US$ is mild compared to that of other currencies, for example, over the last week the Euro fell 2.4%, the Yen fell 3.9% and the A$ fell 2.5%. So it’s not a case of China artificially devaluing their currency ahead of a feared protectionist Trump presidency.
- Cyclical share market sectors are likely to continue to outperform bond proxies such as REITs.
Will President Trump replace Janet Yellen? There is much talk he will replace her with a more hawkish ‘hard money’ chairperson. However, she is answerable to Congress not the president and her current term does not end until the end of January 2018 (until which she has indicated she intends to stay) but by which time Trump may well conclude that it’s in his own interest to retain a more dovish Fed leader for fear that a more hawkish Fed would offset the benefits of his stimulus program via even higher interest rates, bond yields and $US. So it’s premature to conclude he will replace Yellen.
The geopolitical focus is now shifting back to Europe with the upcoming referendum on reducing the power of the Italian Senate and the Austrian presidential election both on December 4 refocussing attention on Eurozone break-up risks. Opinion polls in Austria are pointing to the election of the Euro-sceptic right wing candidate – and although the president is largely ceremonial, his election could add to anxiety about the threat to Europe. Italy is more significant though – the Senate referendum coming on the back of reforms to the lower house of Italy’s parliament are designed to make Italy more governable and clear the way for long needed economic reforms. (Just what Australia needs!) Opinion polls are now leaning to a “No” vote. A “No” vote would probably see PM Matteo Renzi resign with fears that this will lead to an early election with the Euro-sceptic Five Star Movement (5SM) winning, calling a referendum on Italy’s membership of the Eurozone which would then see Italy move to leave. As a result, bond yields in Italy have blown out on fears that at some point Italian debt will be redenominated into a less valuable currency. These fears are likely exaggerated though: the referendum’s failure would just mean messy politics as normal in Italy, it’s unlikely there will be an election before the due date in 2018, even if there was it’s not clear that 5SM would win (its poll support is no longer rising and it’s below support for the governing party) and even if it did and called a referendum on Italy’s membership of the Euro a majority of Italians support staying in the Euro. That said, markets may still worry about what would happen if there is a “No” vote. So it could cause short term volatility but I suspect another bout of share market weakness on Eurozone break-up fears would prove to be yet another buying opportunity just like over the last five years.
Major global economic events and implication
US data was mostly solid. Retail sales rose more than expected in October and were revised up for September, indicating that the consumer is kicking into gear. While industrial production was soft in October, regional manufacturing conditions indexes suggest little reason for alarm, solid home builder conditions and strong housing starts point to solid housing investment and jobless claims remain low. Meanwhile, headline consumer price inflation continues to rise as the impact of the fall in energy prices falls out, but producer price inflation and core CPI inflation was softer than expected. Finally, Janet Yellen’s testimony provided no surprises indicating rates will likely rise “relatively soon” but that the process of rate hikes would remain “gradual”. Bottom line: US growth looks to be running around 3% in the current quarter, consistent with the Fed hiking rates in December, for which the money market is now attaching a 98% probability.
Eurozone GDP growth remained moderate at 0.3% quarter-on-quarter/1.6% year-on-year in the September quarter as widely expected. Business conditions PMIs and confidence readings point to some pick-up in growth ahead.
Japanese GDP growth surprised on the upside in the September quarter, with strength in exports, housing investment and public spending. Last year’s volatility has given way to more steady growth this year with stronger consumer spending likely to help growth going forward.
Chinese economic activity indicators were mixed in October with slower retail sales (albeit 10% yoy is not bad), steady industrial production at 6.1% yoy and a pick-up in fixed asset investment helped by property investment. Having just returned from China, the one thing that struck me is that it’s as busy as ever. If you are waiting for the hard landing long predicted by the China bears it’s a bit like “waiting for Godot”.
Australian economic events and implications
In Australia, the minutes from the RBA’s last Board meeting offered nothing new and a relatively upbeat speech by Governor Lowe indicated that the Bank is happily on hold for now but labour market softness highlights that’s it still too early to rule out another interest rate cut next year. Employment rose in October driven by a gain in full time jobs but left in place a very weak trend for full time jobs consistent with continuing very high underemployment. This in the September quarter resulted in a new record low for wages growth of just 1.9% yoy. The risk is that this in turn will result in lower inflation than the RBA is allowing for and combined with a slowing in the housing sector, upward pressure on bank mortgage rates from rising funding costs and a still too high A$ will drive another rate cut. Bottom line: while global bond yields are on the rise on prospects for stronger US growth and a tighter Fed,this will likely see the Australian interest rate cycle turn up in 2018, though we are still allowing for another RBA rate cut in the first half of next year.
What to watch over the next week?
In the US, the manufacturing conditions PMI (Wednesday) is likely to have remained around solid levels. Expect flat existing home sales (Tuesday) and new home sales (Wednesday) after solid gains in September, continued modest growth in home prices and a bounce in durable goods orders (both Wednesday) but with little change in underlying orders. The Minutes from the last Fed meeting (also Wednesday) will be very dated.
In Europe, manufacturing and services conditions PMIs (Wednesday) are expected to have remained solid at around 53.5, consistent with a slight pick-up in economic growth.
Japan’s manufacturing conditions PMI (Thursday) will be watched for further signs of improvement. Inflation data (Friday) is expected to show continuing headline deflation.
In Australia, a speech by the RBA’s Kent (Tuesday) will be watched for clues on the interest rate outlook. September quarter construction data (Wednesday) is likely to show an ongoing decline in mining engineering investment.
Outlook for markets
While the US election is out of the way, event risks could still cause short term volatility in share markets with policy uncertainty remaining high in the US (watch the senior appointments to Trump’s team), Eurozone break-up risks coming back into focus with the Italian Senate referendum and Austrian presidential election re-run (both on December 4) and ECB and Fed meetings in December. Bond yields could also see more upside in the short term. However, despite continuing volatility we anticipate shares to trend higher over the next 6-12 months helped by okay valuations, continuing easy global monetary conditions, a shift towards fiscal stimulus in the US, moderate economic growth and the shift from falling to rising profits for both the US and Australian share markets.
Sovereign bonds are now very oversold and due for a bounce in price (or pullback in yield). But still low bond yields point to a poor medium term return potential from them. The abatement of deflationary pressures as commodity prices head up, the gradual using up of spare capacity and a shift in policy focus from monetary to fiscal stimulus indicates that the long term decline in yields since the early 1980s is probably over. Expect the trend in bond yields to be up.
Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors though as these two asset classes never fully adjusted to the full decline in bond yields.
Dwelling price gains are expected to slow, as the heat comes out of Sydney and Melbourne thanks to poor affordability, tougher lending standards and as apartment supply ramps up which is expected to drive 15-20% price falls for units in oversupplied areas around 2018.
Cash and bank deposits offer poor returns.
A shift in the interest rate differential in favour of the US as the Fed remains on its path to hike rates should see the long term trend in the A$ remain down.
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