The past week saw geopolitics continue to cause gyrations in markets with political tensions around immigration in Germany and Trump upping the ante on trade with China. This saw most major share markets fall, particularly in Europe and China and at the same time emerging markets remained under pressure not helped by the rising $US fuelling fears about a dollar funding crisis. Australian shares bucked the global lead though. Safe haven demand saw bonds mostly rally, except in Italy where worries resumed. Oil rose but metals and iron ore fell not helped by trade worries. This also saw the $A break below $US0.74 as the $US continued higher.

Despite the trade war threat Australian shares rose more than 2% over the last week and made it to their highest level since early 2008, but is it sustainable?Australian shares have been boosted by a rebound in financial shares which had become oversold the previous week as bargain hunters snapped them up for their dividends, a boost to consumer stocks from the passage of the Government’s income tax package and strong gains in defensives and yield sensitive REITs. This has left the ASX 200 on track for our year-end target of 6300, assuming our base case of no major trade war is correct. However, the road between now and year end is likely to be rough with a high risk that the trade skirmish gets worse before it gets better, and worries around Trump, Fed rate hikes, China, emerging markets and Australian property prices all likely to cause a rough ride. Given that China takes one third of our exports the local market would be vulnerable should the trade war escalate significantly.

Emerging markets under pressure but this is not 1997-98 all over again. From their highs early this year EM shares and currencies are down around 10%. The plunge reflects a combination of country specific problems (eg Turkey, Brazil and South Africa), concerns that the rising $US will cause a dollar funding crisis for emerging countries with significant $US debt, worries that they will be adversely affected by any global trade war and repositioning after investors loaded up on EM assets with a 65% rally in EM shares from early 2016 to early this year. The weakness could have further to go as many of these concerns remain, but it’s unlikely to be a rerun of 1997-98 or even 2015 as EM fundamentals around growth and external balances are arguably stronger than then and the rebound in the $US is likely to be limited.

Trump’s further ramping up of the trade skirmish with China (from tariffs on $US50bn of imports plus another $US200bn should China retaliate and then another $US200bn if China retaliates to that) have significantly increased the risk of a full-blown trade war between the US and China – with a more significant economic impact. So far the bulk of the tariffs are just proposed so there is still room for a negotiated solution which remains our base case as that is what the US is seeking and China would prefer – otherwise the tariffs would have been implemented already. But there is now a high risk that some of the tariffs go into force before a negotiated solution is reached (which would be a short-lived negative for share markets), even though we still see the risk of a full-blown US-China trade war with deeper share market downside as being low at around a 10-20% probability. Key to watch for is the re-start of US-China negotiations ahead of July 6. It was noteworthy that central bankers Powell, Kuroda, Draghi and Lowe all raised the threat of a trade war as a significant risk to the outlook and by implication as a potential downside to interest rates.

Expect measures to strengthen the Eurozone at its summit on Thursday and Friday, but will it be enough. Progress in this direction has been given a big push by French President Macron and German Chancellor Merkel supports many of his proposals. Expect progress on a banking union, measures to strengthen the European Stability Mechanism, possibly a start to a Eurozone budget, some agreement on an unemployment stabilisation fund and a strengthening of European Union border control enforcement. Solving the immigration issue is critical if Merkel is to head off a potential split with her Interior Minister who leads the Bavarian Christian Social Union and is threatening border controls around Germany and to keep Italy onside. A split with the CSU would unlikely spell the demise of Merkel or the German coalition Government as Merkel could get support from the Greens, but Merkel and her party would prefer to retain support from the CSU. A more integrated Europe would be positive for Eurozone assets including the Euro, but no progress would be bad.

The Australian Government got a big win with the Senate passing its personal income tax package. However, the impact on consumer spending is likely to be trivial as the tax cuts for low and middle income earners don’t kick in until after taxpayers do next year’s tax return after June 2019 and are only around $10 a week which maybe buys two cups of coffee and the tax cuts for middle to higher income earners won’t be of any significance until next decade and just give back some bracket creep. So a surge in retail stocks on the news may have got a bit ahead of itself.

Along with slow wages growth and falling house prices in Sydney and Melbourne there are two other drags on Australian households: rising petrol prices and potentially higher mortgage rates. The rise in petrol prices to around $A1.50/litre has pushed the typical Australian household’s petrol bill up by around $12 a week over the last two years.

Short term bank funding costs continue to rise in Australia pointing to potential upwards pressure on some borrowing costs. While US short term funding costs have come down, they have risen further in Australia. The reason for the divergence remains unclear but may be related to a desire to lock in funding ahead of the financial year end (after the squeeze into the March quarter end), the Westfield takeover and regulatory reforms including the impact of the Royal Commission. Whatever the reason the longer its sustained the more it will pressure Australian banks to raise some mortgage rates as banks source 20% of their funding from this source.

Major global economic events and implications

US economic data remains mostly solid. The Philadelphia regional manufacturing conditions index fell in June but remains very strong. Existing home sales fell but home builder conditions remain strong, housing starts and home prices rose, the leading index rose and jobless claims remain ultra low suggesting unemployment will head down further towards 3%.

Japanese core inflation (ie ex fresh food and energy) fell further in May to just 0.3%yoy highlighting that the Bank of Japan’s ultra-easy monetary policy has a long way to run yet.

China is cutting taxes to help boost consumption (with 80% of urban workers to benefit) & the State Council signalled cuts to bank required reserve ratios to boost lending to small business.

Australian economic events and implications

ABS March quarter home price data confirmed the softening in the housing market led by Sydney with Melbourne slowing too. Private sector surveys point to weakness having continued in this quarter. Our assessment remains that Sydney and Melbourne prices have more downside spread over the next 2-3 years as tighter bank lending standards, rising supply and deteriorating capital growth expectations impact with prices likely to see a total top to bottom fall of 15%. Perth and Darwin prices are likely at or close to the bottom, the boom in Hobart may have a bit further to go and Adelaide, Canberra and Brisbane are likely to see moderate growth. While a house price crash is a risk continued strong population growth in Australia of 388,000 people last year led by Victoria is one reason why this is unlikely.

Meanwhile skilled vacancies fell for the third month in a row in May suggesting employment growth may be slowing (other indicators don’t point to this though) and the minutes from the RBA’s last meeting added nothing new. Our assessment remains that the RBA will be on hold out to 2020 at least and weak home prices, along with sub-par growth, uncertainty around consumer spending and low inflation and wages growth are the major reasons for this.

What to watch over the next week?

Geopolitics will remain a focus in the week ahead with the US and China needing to start negotiating again to have any chance of heading of the July 6 scheduled start for US tariffs on imports from China and the European summit on Thursday and Friday taking on added significance given expectations of progress towards a strengthening of European integration and solving the immigration problem.

On the data front in the US expect a rise in new home sales (Monday), further gains in home prices and continued strength in consumer confidence (Tuesday), a rise in core durable goods orders and pending home sales (Wednesday) and strong personal spending data for May with a rise in the core personal consumption deflator to 2% year on year (Friday) which will leave it at the Fed’s target.

Eurozone inflation data for June to be released Friday will no doubt be watched closely but with core inflation likely to fall back to just 1% year on year its likely to reinforce expectations for the ECB to leave rates around zero for a long time. Business and consumer confidence data will also be released.

Chinese business conditions PMIs for June due to be released on Saturday June 30 will be watched for any sign of the slowing evident in activity data for May.

Japanese labour market and industrial production data will be released on Friday.

In Australia, it will be a relatively quiet week with ABS job vacancies data (Thursday) likely to show some slowing and credit growth (Friday) likely to remain moderate with ongoing weakness in investor credit.

Outlook for markets

While we continue to see share markets as being higher by year end as global growth remains solid helping drive good earnings growth and monetary policy remains easy, we are likely to see more volatility and weakness between now and then as the

US trade threat could get worse before it gets better and as worries remain around the Fed, President Trump in the run up to the US mid-term elections, China, emerging markets and property prices in Australia.

Low yields are likely to drive low returns from bonds. Australian bonds are likely to outperform global bonds helped by the relatively dovish RBA.

Unlisted commercial property and infrastructure are still likely to benefit from the search for yield, but it is waning.

National capital city residential property prices are expected to slow further as the air continues to come out of the Sydney and Melbourne property boom and prices fall by another 4% this year, 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%.

The $A likely has more downside to around $US0.70 as the gap between the RBA’s cash rate and the US Fed Funds rate pushes further into negative territory as the US economy booms relative to Australia. Solid commodity prices should provide a floor for the $A though in the high $US0.60s.