Weekly Market Update

Investment markets and key developments over the past week

While US shares fell slightly over the last week on some mixed earnings results most share markets rose with Eurozone shares particularly helped by a dovish ECB. Bond yields rose in the US and UK but fell elsewhere. While iron ore prices fell, oil and copper prices rose. The $US had another leg higher on strong US data and ECB dovishness and this saw the $A break below $US0.77.

As widely expected the ECB announced a further extension of its quantitative easing program at the reduced rate of €30bn a month from January 2018 for nine months and “beyond, if necessary” with ECB President Draghi saying it won’t suddenly stop next October. In doing so the ECB reiterated that interest rates will not be raised until “well after” QE ends which implies not until 2019 at the earliest. Continuing QE and low rates in the Eurozone is a big positive for Eurozone shares and at a time when the Fed is undertaking rate hikes and quantitative tightening points to downwards pressure on the Euro. The continuation of QE in Europe at a time when Japan remains locked on QE and zero 10-year bond yields and the US is only tightening gradually highlights that global monetary conditions will remain easy for a long while yet.

The focus on Catalonia may ramp up a bit going forward if the Spanish Government moves to take control of Catalonia. Negotiations would seem a better way to proceed, but we remain of the view that it’s not a major European (let alone global) issue: a Catalan independence declaration will have little meaning; although there will be some resistance Catalans are unlikely to rise up en masse and resist a central government takeover; and the issue is not about the survivability of the Euro with Catalonia wishing to remain in it.

China’s Communist Party Congress saw an enhanced authority for President Xi Jinping as evident in the new seven-member leadership team, the absence of any heir appointed in the team and his “Thoughts on Socialism with Chinese Characteristics for a New Era” being enshrined in the Party’s constitution. However, we continue to expect a continuation of the recent direction in policy rather than a big shift in direction. But there will be more focus on sustainable growth – supply side economic reforms, rebalancing towards more consumption driven growth and measures to deal with financial risks, pollution and inequality – and less focus on growth for growth’s sake. While there may be less emphasis on growth targets the objective to double 2010 GDP by 2020 implies GDP growth of 6-6.5% pa. So expect growth to remain solid, even though there will be more focus on sustainability. 

Is President Xi “recklessly building China on a foundation of sand” as a well-known US hedge fund manager suggested, presumably as a reference to rising debt? Not that I can see. Yes, debt levels have gone up rapidly but it borrows from itself, it hasn’t blown it on reckless consumption and it is aware of the problem. If anything it saves too much and has the problem that a big chunk of that saving is recycled through its banking system (which means it gets called debt). Yes, it has problems with unequal development and pollution – but so have all rapidly developing economies. Is it fair to criticise China on the grounds that “true developed economies do not impose severe capital controls or move short term interest rates hundreds of basis points overnight in attempts to manipulate their own currency” as the same hedge fund manager also said? Again I don’t think so – China is still a developing economy and most developed economies (the US and Australia included) have had phases of heavy market regulation often well after China’s current level of development.

Progress continues towards tax reform in the US with the House passing the Senate’s 2018 budget which will allow tax reform to proceed under the so-called budget “reconciliation” process. Our assessment is that it now has a 70% chance of getting up by early next year. The biggest risk is that the package loses the support of more than two GOP senators (for ideological reasons, feuds with Trump, poor health or a loss to the Democrats in the Alabama special senate election). Trump’s fights with various Republican senators highlight this risk but it must be remembered that tax cuts/reform are a fundamental Republican objective (ie, it’s much more than Trump) and Republican’s need a big win on something like tax reform ahead of the 2018 mid-term Congressional elections. (It’s worth noting though that some Democrat senators may support tax reform – as they did in relation to the Bush era tax cuts.) There is also uncertainty about the size of the fiscal stimulus tax reform will provide – eg will it rely on a growth dividend (called “dynamic scoring”) to make it revenue neutral over time or will the tax cuts expire after ten years like the Bush era tax cuts? Out of interest the Senate budget allows for a $1.5 trillion net deficit increase due to tax reform over ten years which if spread evenly is about 0.1% of GDP a year but it is likely to be more front loaded.

But at a big picture level, tax reform in the US will mean a small boost (maybe 0.2% to 0.3%) to 2018 GDP growth, a likely additional Fed rate hike (four hikes in 2018 rather than three) and more upwards pressure on US bond yields and the $US. For Australia, US tax reform would mean a lower than otherwise $A, more flexibility for the RBA and more pressure to lower our corporate tax rate (given the risk some companies may choose to relocate their headquarters to the US).

And finally, it was a sad week for the Australian music scene with the death of George Young. Most Australians would know of Lennon and McCartney or Bacharach and David or maybe even Tennant and Lowe and I reckon the song-writing partnership of George Young and Harry Vanda that started with The Easybeats and ran through songs for John-Paul Young, Ted Mulry and others is Australia’s answer to them. Anyway “do yourself a favour” and check George Young out here.

Major global economic events and implications

US data remains strong with strong business conditions PMIs, a rebound in new home sales, solid gains in durable goods orders pointing to solid business investment and ultra low jobless claims. After a soft hurricane affected September quarter growth looks to have rebounded in the current quarter. September quarter earnings reports have continued to surprise on the upside with 79% beating on earnings and 68% beating on sales. However, earnings growth estimates for the quarter have fallen to around 2.5% year on year from 4% after being dragged down by GE and insurers.

Eurozone business conditions PMIs remain strong (up for manufacturers and down for services) and the German IFO has almost reached its highest level since 1969.

Australian economic events and implications

Australian inflation surprised again on the downside for the September quarter and so rate hikes are still a way off. Our view remains that the RBA won’t raise interest rates until late next year as it will take a while for a gradual pick-up in economic growth to flow through to wages growth and higher underlying inflation. RBA Deputy Governor Debelle’s reference to sizeable spare capacity in the labour market and flat Phillips curves implies ongoing RBA concern about low wages growth.

What to watch over the next week?

In the US, the Fed (Wednesday) is expected to leave interest rates on hold but indicate that recent weakness in inflation is likely to be temporary given strong indications regarding growth and that as such it remains on track to raise interest rates again in December and that quantitative tightening is proceeding as planned. On the data front, the main focus will be on October jobs data (Friday) which is expected to show a 300,000 rebound in payrolls to make up for the hurricane driven 33,000 decline seen in September. Unemployment is expected to remain around 4.2% but wages growth may also slip back a bit to 2.7% year on year. Meanwhile, expect to see strong growth in personal spending but continued low core inflation for September (Monday), ongoing gains in home prices, solid consumer confidence and an edging up in employment costs (all Tuesday), continued strength in the ISM manufacturing index (Wednesday) and a slight worsening in the trade deficit (Friday). September quarter earnings results will also continue to flow.

President Trump will likely also announce his nomination for Fed Chair – it seems to have come down to a choice between existing Chair Yellen, current Fed Governor Jerome Powell and academic John Taylor. Yellen and Powell would be seen as more of the same and Taylor who advocates a rules based approach may be seen as more hawkish. However, it’s doubtful the choice will change the tightening path the Fed takes over the next year, but Taylor may be slower to respond in the event of a crisis.

Eurozone data is expected to show continued strong readings for economic confidence (Monday), a fall in unemployment to 9%, a rise in September quarter GDP growth of 0.6% quarter on quarter or 2.5% year on year and only a slight lift in underlying inflation (all Tuesday) to 1.1% year on year.

Japanese data is expected to show continued labour market strength, a pick up in household spending growth and some slowing in industrial production (Tuesday). But reflecting ongoing near zero core inflation the Bank of Japan which also meets on Tuesday is expected to continue quantitative easing and keep the 10-year bond yield around zero.

China’s manufacturing conditions PMIs (Tuesday and Wednesday) are expected to point to continued solid growth.

In Australia, expect continued moderate growth in credit (Tuesday), CoreLogic data (Wednesday) to show further evidence of a moderation in home price growth, a 1% fall in building approvals (Thursday) and a 0.3% gain in September retail sales (Friday) after two months of falls. September quarter real retail sales data is expected to show a sharp slowing.

Outlook for markets

We are moving into a more favourable part of the year for shares from a seasonal perspective but North Korean risks remain high, Trump related risks remain and Wall Street is overdue for a decent 5% or so correction which would affect other share markets. However, beyond short term uncertainties we remain in a sweet spot in the investment cycle – with okay valuations particularly outside of the US, solid global growth and improving profits but still benign monetary conditions – so we remain of the view that the broad trend in share markets will remain up. This has already helped drag Australian shares up out of their June to September range bound malaise.

Bond yields look to be starting to break higher again, led by US bonds. Low starting point bond yields and a likely rising trend in yields will likely drive poor returns from bonds.

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

Residential property price growth in Sydney and Melbourne looks to have peaked with a slowdown likely over the next year or two, but Perth and Darwin are likely close to the bottom, Hobart is likely to remain strong and moderate price gains are expected to continue in Adelaide and Brisbane.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.25%.

With the RBA on hold for the next year or so and the Fed on track to hike in December with another three or four hikes next year the interest rate differential will continue to move against Australia which should result in further weakness in the $A.