25 November 2016
The past week saw the rally in shares continue helped by good global data, rising commodity prices and ongoing optimism regarding President elect Trump’s stimulus plans. US shares rose 1.4%, Eurozone shares rose 0.9%, Japanese shares rose 2.9%, Chinese shares rose 3% and Australian shares gained 2.8%. The main drag though is the continuing rise in the US$ which has broken out to its highest level against an average of major currencies since 2003. Despite this commodity prices rose; making the latest bout of US$ strength more positive than that seen in 2014. Higher prices for bulks, metals and energy saw resources shares lead the charge higher in Australian shares over the last week. Despite the rising US$, the A$ rose helped along by higher commodity prices. Bond yields continued to rise in the US and Australia.
Brexit, Trump, Le Pen…or is Europe different? Naturally after the recent experience in the UK and US which is indicative of a resurgent nationalist backlash against the pro-globalisation establishment there is a fear that Europe will go the same way. But there are several reasons for thinking that Europe is different – that a populist driven break up won’t happen. First, Europe does not have the same issues with inequality that has driven the “leftist” backlash in the UK and US. It has always been well to the left of Anglo countries. Second, the maximum risk point in the Eurozone was arguably just after the Eurozone debt crisis a few years ago when austerity and unemployment were at their peak. Third, despite the media excitement the increase in support for the Euro-sceptic populists following Brexit, Trump, etc, has not really been overwhelming. Support for Le Pen and the National Front in France has been stuck around 25%. The Five Star Movement in Italy looks to have peaked in the polls and polls less than the governing party. Alternative for Deutschland only gets about 15% support. Finally, support in mainland Europe for the European Union and Euro is high. Perhaps the two main pressure points in Europe are the migration crisis and austerity – but the migration crisis is abating and austerity looks to be over with the European Commission even recommending recently that member countries adopt a more expansionary stance. Risks are high though and the December 4 Austrian presidential election and Italian Senate referendum could add to fears about a break up. But the evidence suggests that Europe is not the same as the UK and the US and that bouts of share market weakness on Eurozone breakup fears should be seen as buying opportunities.
The soap opera about Australia’s AAA sovereign rating is back on again, but does it really matter? While the surge in bulk commodity prices should boost corporate tax revenue this looks like being offset by lower personal tax collections due to lower wages growth so yet another budget blow out is possible. Meanwhile S&P has Australia on negative outlook and has warned of a downgrade if there is any further delay in return to balance by 2020-21. Given the continuous delays of recent years and Australia’s continuing dependence on foreign capital the odds of a downgrade are high. But would it matter? First based on other countries that have been downgraded it’s 50/50 as to whether borrowing costs would actually rise in response to a downgrade. Italy and Spain have lower ratings than Australia and yet have lower borrowing costs. And in any case if mortgage rates do rise in response to a downgrade the Reserve Bank of Australia (RBA) can always cut the official interest rate in order to bring them back down to where it wants them. In fact the main blow from a downgrade would be what it tells us about the deterioration in the quality of economic policy making in Australia.
Australian mortgage rates on the way back up? The past week has seen several lenders raise fixed rate mortgage rates. This is a natural reaction to the back up in bond yields which drive the funding costs for fixed rate mortgages. Major bank variable rates are at risk of out of cycle increases but it’s hard to see them rising significantly any time soon as we don’t see the RBA raising the cash rate until 2018 (see below).
Major global economic events and implication
US economic data remained solid. The Markit manufacturing conditions PMI, consumer sentiment, durable goods orders and existing home sales all rose more than expected and the services PMI remained strong. December quarter GDP growth is tracking around 3% annualised and the US money market is pricing in a 100% probability of a December rate hike by the US Federal Reserve (Fed).
Eurozone business conditions PMIs also rose further in November and are tracking at levels consistent with a pick-up in GDP growth to around 2%. Consumer confidence also rose.
Japan’s manufacturing PMI slipped but remains well up from mid-year lows, and inflation rose but remains weak.
Australian economic events and implications
An upbeat RBA versus a possible slump in September quarter GDP growth…what gives? Assistant RBA Governor Kent painted a relatively upbeat view of the economic outlook similar to that portrayed by Governor Lowe the week before. By contrast September quarter construction activity fell much more than expected and along with likely weak net export volumes and soft retail sales points to weak, possibly even slightly negative, September quarter GDP growth, which if reported in early December will no doubt reinvigorate concerns about the Australian economy. However, while the RBA may be a bit too upbeat I wouldn’t read too much into likely soft September quarter GDP because it will be payback for much stronger than expected growth over the year to the June quarter of 3.3%. Looking forward the ramp up in resource export volumes has further to go, approvals data point to a bounce back in dwelling construction and strengthening non-dwelling investment, mining investment is getting close to a bottom with engineering work back to around its long term trend (see chart), recent retail sales data have improved and the rebound in commodity prices tells us that the income recession is over. Given the possible September quarter soft patch in growth and downside risks in inflation we are still allowing for one more interest rate cut next year but overall growth is likely to be around 3% in 2017 which will help set the scene for a likely RBA rate hike in 2018.
Source: ABS, AMP Capital
What to watch over the next week?
OPEC, US payrolls, the Austrian presidential election & Italian Senate referendum and Australian capex data will likely be the main focus points in the week ahead.
It’s a close call, but our assessment is that OPEC (Wednesday) will probably reach agreement on a production cut as inventories are rising, Iran is at maximum capacity and Saudi Arabia wants to re-establish its position as the leader of OPEC. This should help the oil price but it may not get much higher as US shale oil production looks like its ramping up again, lighter energy regulation under a Trump administration will likely also add to US oil production and OPEC discipline around any cut will be debatable. But it will add to the case that it’s bottomed.
In the US, expect a solid rise in the ISM manufacturing conditions index (Wednesday) for November and solid payroll employment growth (Friday) of 180,000 to support expectations for another Fed rate hike in December. The jobs data is likely to show unemployment unchanged at 4.9% and wages growth holding at 2.8%. Meanwhile expect a rise in consumer confidence and further gains in home prices (both Tuesday), solid personal spending but the core personal consumption deflator remaining around 1.8% yoy and little change in pending home sales (all Wednesday).
In the Eurozone, all eyes will be on the Austrian presidential election and Italian senate referendum to be held on Sunday December 4. Opinion polls point to a victory by the right wing Eurosceptic candidate in Austria and a “No” vote in Italy both of which will lead to an increase in Eurozone break up fears. But there will be a long way to go before either country will have a referendum on Eurozone membership (if indeed they do) and as we have seen with Greece a majority of the population support staying in the Euro. On the data front, economic confidence indicators (Tuesday) are expected to show further strength and core inflation (Wednesday) is likely to have remained around 0.8% year on year.
Japanese jobs data for November is likely to have remained strong but household spending (both Tuesday) is expected to have remained soft and industrial production (Wednesday) relatively subdued.
Chinese manufacturing PMIs (Thursday) for November may slip back a bit but are likely to remain in a rising trend.
In Australia, September quarter business investment data (Wednesday) is expected to show continued mining driven weakness but with signs that mining investment is getting close to the bottom and that non-mining investment plans may be improving. Meanwhile, expect a bounce in building approvals and continued moderate credit growth (both Wednesday) and a 0.2% gain in October retail sales (Friday).
Outlook for markets
Shares are now overbought & due for a pause and event risk could cause short term volatility with policy uncertainty remaining high in the US, Eurozone break up risks coming back into focus with the Italian Senate referendum & Austrian presidential election re-run and ECB and Fed meetings in December.Bond yields could also see more upside in the short term. However, we anticipate shares to be higher by year end as seasonal strength kicks in (the “Santa rally”) and see share markets trending higher over the next 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 Australia.
Sovereign bonds are now very oversold and due for a 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 AS remain down.
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