2 March 2018
Investment markets and key developments over the past week
Share markets turned back down over the last week as fears relating to inflation and US Federal Reserve (the Fed) rate hikes continued to ramp up on the back of the Fed’s Chair Powell’s Congressional testimony, not helped by President Trump’s announcement of tariffs on US imports of steel and aluminium. The tariff announcement weighed a bit on the Australian share market, with worries about the direct impact on Australian producers and the threat of a trade war, but as in early February it proved to be relatively resilient. Over the week US shares fell 2%, Eurozone shares lost 3.4%, Japanese shares fell 3.3%, Chinese shares fell 1.3% and Australian shares lost 1.2%. Bond yields were flat to down, slightly helped by safe haven demand and commodity prices fell as did the Australian dollar.
We remain of the view that the pullback in share markets seen last month is a correction as opposed to the start of a major bear market, but we may not have seen the last of February’s share market lows. With US inflation and Fed expectations still moving higher and Trump adding to the inflationary pressure in the US with tariff hikes, share markets are likely to remain volatile in the short term with a high risk of seeing a re-test of February’s share market lows.
Trump’s intention to impose a 10% tariff on imported aluminium and 25% on steel is bad policy at a bad time and will only add to the risk of a trade war, but don’t get too carried away. It’s bad policy because tariffs don’t work – a review of the 2002 8-30% US steel tariffs imposed by President Bush found that “the costs of the Safeguard Measures outweighed their benefits”. Trump also doesn’t seem to understand that America only has a trade deficit because it spends more than it earns each year. His budget deficit blow-out will only add to this reality. And it’s bad timing because the US economy and labour market is already running hot. It doesn’t need more “help”. This will only add to production costs and inflation in the US and further increase the pressure on the Fed. And it runs the risk of stoking a trade war as other countries retaliate, which is bad for world trade and could threaten global growth. However, it’s important to put it all into some perspective.
- First, it’s not that surprising as Trump has long been a protectionist, the US has recently been stepping up the action on this front (with tariffs on solar panels and washing machines recently) and there was a high likelihood that Trump would go down this path to appeal to his base ahead of the mid-term Congressional elections. At least it’s not the 35% across the board tariff on Chinese imports Trump talked about during his election campaign.
- Second, the direct impact of US steel and aluminium tariffs is small. Total US steel and aluminium imports are just 0.25% of US gross domestic product (GDP). Canada is most exposed, with its steel and aluminium exports to the US totalling 0.7% of its GDP but even that is minor. After Canada, most exposed countries are Russia (0.3% of GDP), Mexico (0.3% of GDP) and South Africa (0.1% of GDP). For China, the impact is trivial. Only 1.6% of China’s steel exports and 16% of its aluminium exports go to the US (equal to a total of just 0.03% of its GDP) so the direct impact on China will be modest, which in turn should mean a relatively modest impact on Australian miners. Australia is not a significant exporter of steel or aluminium to the US, at less than 0.02% of GDP.
- Finally, the risk of a global trade war (in which the US measures beget retaliation, and then more retaliation by the US in response, and so on in a spiral of protectionism) has gone up, and getting caught up in this is the main risk for Australia, given our 19% ratio of exports to GDP (in contrast to the US at 12%). But again, it’s dangerous to overstate the risk here. The Bush 2002 steel tariffs did not result in a trade war or hamper the global economic recovery from the tech wreck. China is the country to watch, given likely US action against it soon on the intellectual property front. However, apart from loud protests the reaction of most major countries including China is likely to be restrained and at worst proportional to the US moves with the focus likely to be on mounting a WTO challenge. China in particular is likely to want to enhance its image as the “good guy” in terms of supporting free trade. And Trump won’t want to go too far on tariff hikes for consumer goods because his supporters won’t be happy if much of what they buy at Walmart starts to go up a lot in price! So the risk of an escalation into a trade war is there, but at this stage it’s not high enough to justify changing our positive view on the global growth outlook or the outlook for the Australian economy.
Fed Chair Powell’s first Congressional Testimony was slightly hawkish. While Powell’s prepared comments were pretty balanced, his answers to questions indicated he wasn’t concerned about a bit of market volatility and that he is leaning to four rate hikes this year. Since the December Fed meeting, which had three hikes in the so-called dot plot, global growth and US fiscal policy have become tailwinds to US growth and confidence in the US outlook has increased. The dots may not get to four at the March FOMC because it would require four of the six Fed officials currently on three hikes to move to four, and recent comment from Fed officials has had a more cautious tone. However I think that’s where they are ultimately heading. Our view has long been and remains that the Fed will do four hikes this year (possibly five!). The Fed will still be “gradual” but just less gradual that it has been so far this tightening cycle, as the strong growth and inflation outlook mean that it has more work to do to get back to a now rising neutral rate. So markets still have more adjusting to do, with the US money market still only factoring in three hikes for this year. This adjustment won’t go in a straight line, but it means ongoing volatility as investors adjust to higher US interest rates and should be positive for the US$ as the Fed continues to tighten ahead of other central banks.
Bank of Japan’s (BoJ) Kuroda starting to think about when to start thinking about how to exit easy money, but it’s a long way off yet. The BoJ expects inflation to be at its 2% target around 2019, so Kuroda’s comment that it will start thinking about exiting in fiscal 2019 isn’t that surprising. However, fiscal 2019 goes from April 2019 to March 2020 so it could be two years away before they even start thinking about it and in any case we have to get to 2% inflation first, with the rising Yen will only make that harder. This could in turn further delay the exit.
66% of German Social Democrat Party members back coalition agreement with Angela Merkel. This was a clearer vote than had been expected and will now see Merkel confirmed as Chancellor for a fourth term. It also clears the way for Merkel to work with Macron to further strengthen the Eurozone (in areas like a banking union), particularly with the even more pro-Europe Democrats taking control of the Finance Ministry. The trick will be to strengthen Europe, but not in a way that further encourages support for the far-right nationalist Alternative for Deutschland.
The Italian election is a bit messier, with exit polls putting the populist centre right coalition between Forza Italia, the Northern League and Brothers of Italy ahead on 33-36%, the Five Star Movement at 29.5%-32.5% and the Democratic Party at 20-23%, all short of the 40% threshold needed to form government. The centre right coalition may be given first go at trying to form government, however based on the exit polls (which may be less reliable than normal given the new electoral system), it’s not clear they will get there. A Democratic Party and 5SM coalition may be the best outcome in terms of fiscal responsibility – but would just mean more of the same muddling along in Italy. A populist Euro-sceptic coalition between the Northern League and the 5SM would probably be the worst outcome but looks unlikely given their political differences. Another grand coalition between the Democratic Party and Forza Italia is highly possible and would be a continuation of the current government – and again more muddling along. The new parliament does not sit until 23 March and after that the President will meet with party leaders and give a mandate to attempt coalition formation. So it may be some time before the final outcome is known. The Italian election is unlikely to threaten an Itexit (an Italian exit from the euro) in the short term, but it does run the risk of making Italy’s public finances worse than they already are, with no progress in addressing Italy’s long-term competitiveness problems. Not great – but probably not enough to threaten the greater European integration agenda that Germany and France are likely to pursue.
Major global economic events and implications
US economic data was a mixed bag over the last week. Home sales fell in January with higher mortgage rates and reduced mortgage interest deductibility probably impacting, durable goods orders were softer than expected, consumer spending was soft in January and the trade deficit was worse than expected. December quarter GDP growth also got revised down slightly but this was due to weaker inventories with final demand actually very strong. However, against this backdrop consumer confidence rose to its highest since early last decade and household disposable income rose strongly in January, pointing to a bounce back in consumer spending, the ISM manufacturing conditions index rose to boom time levels, jobless claims fell to their lowest since 1969 and home prices are continuing to rise. The core consumption deflator, which is the Fed’s preferred inflation measure, remained at 1.5% year-on-year in January, but it’ been running around 2% annualised over the last six months and looks likely to head higher on the back of the strong economy. All of which supports the Fed in raising interest rates four times this year and highlights the danger Trump is running in terms of tariff hikes on top of fiscal stimulus.
The US December quarter earnings reporting season is now effectively done with profits up 16% for the year to December, earnings up 8% and expectations for profit growth this year revised up to 20.6%. This is very supportive of shares, beyond uncertainties around the Fed and bond yields.
Eurozone economic confidence fell in February but remains very high consistent with strong growth, bank lending to the private sector is continuing to accelerate and unemployment fell further to 8.6%. Meanwhile, core Eurozone inflation was unchanged in February at just 1% year-on-year which will keep the European Central Bank (ECB) patient in terms of thinking about when to start removing its easy monetary policy.
Japanese industrial production fell surprisingly sharply in January, but the still robust manufacturing PMI indicates that it will bounce back. Meanwhile the labour market remains very strong with unemployment falling to the lowest since 1993.
Chinese business conditions PMIs were a bit confusing, with falls in official PMIs but a small rise in the Caixin manufacturing PMI. Growth may be slowing in China, but only a touch.
Australian economic events and implications
In Australia, capital expenditure data provided more confidence that business investment has bottomed but the investment growth outlook remains soft. December quarter business investment was basically flat but with good growth in equipment and non-mining investment. The good news is that investment plans for both 2017-18 and 2018-19 were increased compared to those of a year ago. The disappointing news though is that the upswing in overall investment in prospect is modest, as mining investment remains a drag (albeit a diminishing one) and it’s partly offsetting the improvement in non-mining investment. There is nothing here to bring forward rate hikes by the Reserve Bank of Australia (RBA). Other data was mixed, with strong business conditions PMIs, moderate credit growth and another month of falls in house prices in February, driven by Sydney. Our assessment remains that Sydney and Melbourne property prices have more downside but that the total top to bottom fall will be limited to around 5-10% (with Sydney already down by 4.8%) in the absence of much higher interest rates or unemployment (both of which are unlikely).
Solid broad-based profit growth with a good outlook will help the Australian share market, but it’s still lagging global profit growth. The profit reporting season for the December half is now done and has been pretty good. 46% of results have exceeded expectations (against a norm of 44%), 74% of companies have seen profits rise from a year ago (compared to a norm of 65%) which is the strongest since the GFC and 66% have increased dividends from a year ago, with 26% keeping them flat, which is a sign of ongoing confidence in the outlook. Reflecting the reasonable quality of results, 59% of companies saw their share price outperform the market the day results were released (against a norm of 54%). Consensus profit growth expectations for this financial year remain around 7%, with resources upgraded slightly to 16% and the rest of the market downgraded to 5% (from 6%) owing to a downgrade to banks. Profit growth expectations for 2018-19 have been upgraded to 5% (from 4%) thanks to resources. This is good news and will underpin a rising trend in the Australian share market. That said, local profit growth continues to lag global profit growth, where it’s running around 14%.
In the US, the focus will be on Friday’s jobs report for February and specifically whether we will see a further increase in wages growth similar to the January report and which kicked off a plunge in share markets. Expect a 180,000 gain in payrolls, a fall in unemployment to 4% and wages growth unchanged at its January level of 2.9% year-on-year. In other data, expect the February non-manufacturing conditions ISM index (Monday) to have slipped a bit but to still be at a strong level and the trade balance (Wednesday) to show a deterioration. The Fed’s Beige Book (also Wednesday) will be watched for ongoing signs of building inflation.
Both the ECB (Thursday) and Bank of Japan (Friday) are Iikely to remain on hold, staying on auto pilot for now with their ultra-easy monetary policies. The ECB will be watched for signs of a taper in its quantitative easing program after September, but is likely to reiterate that rate hikes won’t occur until well after QE has ended which probably means around mid-2019. By contrast the BoJ is likely to reiterate that it has no plans yet to start winding back its ultra-easy monetary policy.
In China, the key to watch in the National People’s Congress that commences on Monday is the balance between growth and reform, particularly around financial deleveraging. The 2018 growth target is expected to be around 6.5%, but if it looks like the focus is shifting more towards reform and financial deleveraging – implying a greater tolerance for weaker growth – then this could raise concerns about China’s growth outlook. I wouldn’t be too fussed though, as the tolerance for lower growth likely remains low, given the risks around social instability. Chinese trade data (Thursday) is expected to show continued solid growth in exports of around 10% but a slowing in imports to 15% and CPI inflation (Friday) is expected to rise to 2% year-on-year, with a further slowing in producer inflation to 4%.
In Australia, the RBA (Tuesday) will leave rates on hold for the 19th month in a row. Solid business conditions and jobs growth along with RBA forecasts for stronger growth and inflation down the track argue in favour of a rate hike. However weak wages growth and below target inflation, risks around the outlook for consumer spending and the still too high A$ argue for rates to remain on hold or to be cut. And the cooling Sydney and Melbourne property markets provide the RBA with plenty of flexibility. So the RBA is likely to remain comfortably on hold. We don’t expect a rate hike until late this year at the earliest. In a speech on Wednesday, Governor Lowe is likely to reinforce the impression the RBA is comfortably on hold for now.
On the data front in Australia, December quarter GDP data (Wednesday) is likely to show growth of 0.2% quarter-on-quarter or 2.2% year-on-year as net exports (due Tuesday) detract 0.7 percentage points from growth, but this is offset by a bounce back in consumer spending and growth in business investment. Meanwhile, expect building approvals (Monday) to show a bounce after a plunge in December, January retail sales (Tuesday) to show modest growth, consistent with mixed to soft reports from retailers and the trade deficit (Thursday) to show an improvement to -$200 million after a recent run of poor results.
Outlook for markets
Volatility in share markets is likely to remain high and we may see a retest of February’s share market lows, with investors yet to fully digest the outlook for higher inflation and interest rates in the US, but the broad trend in share markets is likely to remain up as global recession is unlikely and earnings growth remains strong globally and solid in Australia. We remain of the view that the S&P/ASX 200 index will reach 6,300 by end 2018.
Low yields and capital losses from rising bond yields are likely to drive low returns from bonds.
Unlisted commercial property and infrastructure are still likely to benefit from the search for yield by investors, but it is waning, and listed variants remain vulnerable to rising bond yields.
National capital city residential property price gains are expected to slow to around zero as the air continues to come out of the Sydney and Melbourne property boom and prices fall by around 5%, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms.
Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.
After reaching as high as US$0.8136 in January which is near the top of the technical channel it’s been in since 2015, the A$ is on the way back down again against the US$, and this is likely to get a push along as the gap between the RBA’s cash rate and the US Fed Funds rate goes negative this month. Solid commodity prices will provide a floor for the A$ though.
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