Weekly Market Update 4 May 2018

Investment markets and key developments over the past week

Despite a 1.3% rally on Friday after another “Goldilocks” jobs report US shares fell 0.2% over the last week, but other share markets fared better over the week with Japanese shares flat, Eurozone shares up 0.9%, Chinese shares up 0.5% and Australian shares up 1.8%. Bond yields were flat to down. The oil price rose to its highest in 3 years as worries about the return of sanctions on Iran continue to build, but the US$ continued to rise, and this weighed on the A$.

Why have Australian shares rebounded? From their early April low Australian shares are up 5.5% and have been helped by reasonable earnings news from Australian companies, solid commodity prices, a fall in the Australian dollar which makes Australian companies more competitive and some fading in trade war fears. But it’s not just the Australian share market. Eurozone and Japanese shares have had even stronger rebounds from their lows helped by a fall in their currencies. But the rebound in the US$ has constrained the US share market.

Geopolitical risks heating up again, but so far so good. May is going to be a big month on the geopolitical front with various US allies’ exemptions to the steel and aluminium tariffs expiring on May 1, the US deadline to fix the Iran nuclear deal expiring on May 12, the public consultation period for tariffs on China due to expire on May 21 and the US Treasury Secretary due to report on proposed restrictions on Chinese investment in the US by May 21. So far so good with the US reaching deals with Australia, Argentina and Brazil on the steel and aluminium tariffs and extending the exemption for Canada, Mexico and the EU until June 1. Negotiations between the US and China have also started on trade, but it was no surprise that the initial two-day negotiation ended without resolution of key issues. A disagreement over trade practices that has built up over more than two decades will take more than two days to resolve. But at least they have shared views and agreed to keep talking. US heavy handed demands of China look like an ambit claim. Again, classic Art of the Deal stuff. A negotiated solution remains most likely, but it will take time with a lot of posturing and near-death moments along the way. Ultimately a deal will likely be reached – that’s been the whole point of the US threats and China is open to negotiation – but it likely won’t be resolved until after May 21 and so we may see a brief start up to tariffs or a delay to their start up if negotiations are going quickly. On the Iran nuclear deal, its likely Trump will not waive trade sanctions against Iran – this will mean that around 0.7million barrels a day of Iranian oil exports will be lost to the market (against total global production of around 100mbd) which could result in further upwards pressure on oil prices. But it’s likely to be minimal as oil prices have already moved up in anticipation. Finally, risks around the Mueller inquiry are continuing to hot up. All of which points to ongoing volatility in markets.

There were no surprises from the Fed which remained on hold but remains on track for more hikes. The Fed is upbeat on growth and recognises that inflation is close to its 2% target and will soon run above it. Its new reference to the inflation target being “symmetric” indicates it won’t slam on the brakes just because inflation is above 2%. But it remains on track for more “gradual” rate hikes. We expect three more hikes this year with the next move to come next month at which point the “dot plot” will move up to three more hikes this year too.

There were also no surprises from the Reserve Bank of Australia which also left rates on hold – for a record 21 months and is set to leave them on hold for much longer. While the global backdrop, business conditions, non-mining investment and infrastructure activity are positive and will lead to some acceleration in growth, uncertainty remains around the outlook for consumer spending, household debt is high, banks are tightening lending standards, wage growth and inflation remain low and will pick only gradually and house prices are falling. As a result, the RBA is likely to remain on hold for a long time yet and we don’t see a rate hike until 2020 at the earliest. While the RBA’s latest Statement on Monetary Policy revised up slightly its underlying inflation forecast for this year to 2% and revised up its unemployment forecast to 5.5% the moves are not enough to change the interest rate outlook. It still doesn’t see inflation getting back to the mid-point of the 2 to 3% target over the two years of its forecast horizon and we remain of the view that its forecasts for 3.25% growth are too optimistic.

The 2018 Australian Federal Budget to be handed down on Tuesday 8^th May will be a pre-election budget made possible by a revenue windfall. A big improvement in in the underlying budget position on the back of increased corporate tax revenue, strong employment growth and lower spending is expected to see the deficit for this financial year fall to $17bn from the $29bn projected in last year’s Budget. This would allow the projected return to surplus to be brought forward a year to 2019-20 but the Government is likely to “spend” much of the revenue windfall as a pre-election sweetener and leave the return to surplus in place for 2020-21. The key elements of this pre-election budget stimulus – which will amount to around $7-8bn a year or 0.3% of GDP – are likely to be personal tax cuts for low and middle-income earners possibly starting as early as July this year but more likely in July 2019, the dropping of the 0.5% increase in the Medicare levy, more infrastructure projects and maybe some increase in health spending. Financial sector regulation may also get a boost in view of the Royal Commission. And the Government may announce a cut to its immigration intake. Key Budget numbers for 2018-19 are expected to be: a Budget deficit of $13bn (assuming the tax cuts kick in from July 2019), real GDP growth of 3%, inflation of 2.25%, wages growth of 2.5% and unemployment of 5.5%.

The upside of the Australian Government’s Budget strategy is that consumers will be given a shot in the arm at a time of soft wages growth, falling home prices in Sydney and Melbourne and tightening bank lending standards. And the budget stimulus of around 0.3% of GDP will be nowhere near the 2% of GDP seen recently in the US.  The downside is that we will still be seeing a record 11 or 12 years of budget deficits with nothing put aside for the next rainy day and there is a risk that the revenue surprise seen lately will prove ephemeral if global growth is threatened and/or employment slows.

Major global economic events and implications

US data was mostly strong. Construction activity fell in March and the ISM business conditions indexes slipped. However, the ISM indexes remain very strong, personal spending rose solidly in March after a soft patch, pending home sales rose, the trade deficit narrowed in March and labour market indicators remain strong. It was another “Goldilocks” jobs report for April with still solid jobs growth and benign wages growth of 2.6% year on year. However, the fall in unemployment to just 3.9% highlights that the labour market is continuing to tighten and that wages growth will soon push higher. The core private consumption deflator rose to 1.9% year on year in March and has risen at an annual pace of 2.3% over the last six months. It looks like it’s going to be at 2% faster than the Fed was forecasting. US March quarter earnings results are now 80% done, with 77% beating on profits and earnings running up 24% on a year ago.

Eurozone GDP growth slowed to 0.4% in the March quarter or 2.5% year on year and April core inflation slowed to just 0.7%yoy (from 1%yoy). While we expect growth to remain around 2.5% and the fall in core inflation should prove temporary, the ECB is likely to remain in wait and see mode.

Japanese PMIs rose in April pointing to stronger GDP growth.

Chinese business conditions PMIs were little changed in April suggesting that economic growth is continuing to hold up well.

Australian economic events and implications

Australian data was a bit better than expected. Building approvals rose more than expected in March, April business conditions PMIs remain strong and the trade surplus was much stronger than expected with net exports likely to provide a solid boost to March quarter GDP growth and business credit growth picked up. But against this home prices continued to fall in April and new home sales continue to fall. The tightening in bank lending standards was highlighted by ANZ CEO Shayne Elliot who said it “…will probably make it harder for people to be successful in their [loan] applications. It is more likely we will say no when in the past on balance we would have said yes.”

What to watch over the next week?

In the US, expect to see continuing strength in small business confidence and job openings (Tuesday) and a further lift in annual core CPI inflation to 2.2% (Thursday).

Chinese data for April is expected to show export growth bouncing back to around 8% year on year (after Lunar New Year holiday distortions drop out) and import growth slowing to 13%yoy (both Tuesday), CPI inflation Thursday) falling further to 1.9%yoy and credit growth remaining solid.

In Australia, the main focus will be Tuesday’s Budget, but expect the April NAB business survey (Monday) to show that business conditions remain reasonably solid, March retail sales (Tuesday) to show modest growth of 0.2% in the month and real growth of 0.4% for the March quarter thanks to weak retail prices and housing finance (Friday) to remain soft.

Outlook for markets

Volatility in share markets is likely to remain high as US inflation and interest rates move up and as issues around President Trump (trade, Mueller inquiry, etc) continue to impact ahead of the US mid-term elections in November, but the medium-term 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 continue to expect the ASX 200 to reach 6300 by end 2018.

Low yields and capital losses from rising bond 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 by investors, but it is waning, and listed variants remain vulnerable to rising bond yields.

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 5% 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$ is short term oversold and due for a bounce, but it likely has more downside to around US$0.70 as the gap between the RBA’s cash rate and the US Fed Funds rate pushes further into negative territory. Solid commodity prices should provide a floor for the A$ though.