Investment markets and key developments over the past week
Share markets pushed higher over the last week as the US Federal Reserve (the Fed) and the European Central Bank (ECB) strongly hinted at monetary easing ahead and as it was confirmed that Presidents Trump and Xi will meet on the sidelines of the 28-29 June G20 meeting in Japan. US shares rose 2.2%, Eurozone shares rose 2.1%, Japanese shares gained 0.7%, Chinese shares rose 4.9% and the Australian share market gained 1.5%. Expectations for monetary easing saw bond yields push even lower with a new record low in Australia. Commodity prices rose, with oil boosted after Iran shot down a US drone, further escalating Middle East tensions and iron ore reaching a new five year high. The A$ rose above US$0.69 as heightened expectations for Fed easing pushed the US$ down.
Rising Middle East tensions again posing a threat to oil prices. Following the US tightening of oil export sanctions on Iran, attacks on several ships around the Strait of Hormuz, the downing of a US drone, an increase in US military presence in the region in response and Iran planning to resume uranium enrichment on 27 June 27, It’s clear that the risk of military conflict with Iran has increased. This could threaten the passage of oil through the Strait of Hormuz through which nearly 20% of world crude oil moves. That President Trump ordered a strike on Iran but then cancelled it (as it wasn’t proportionate) may suggest he prefers a negotiated solution and he was elected on a platform of avoiding wars in the Middle East. Tensions/wars there have also flared up regularly over the years only to fade back down again or end with no more than a short term impact on oil prices, the global economy and share markets and the same could be expected this time. But any significant further flare up from here could cause a bout of weakness in global markets.
Round three of US/China trade talks on the way? It’s very good news that Presidents Trump and Xi will meet to try and re-start trade talks. Ultimately, I expect a deal, as it’s in both sides’ interests given the economic damage being caused by not resolving the issue. Whether this meeting gets us there though remains to be seen given the damage to goodwill that has already been done. It’s noteworthy that Trump seemed a lot keener on the talks – having had another “very good” call with Xi – than the Chinese side which simply acknowledged that they would go ahead. China may just listen politely and conclude they would be better of negotiating with a more conventional president.
Of course, the big difference between now on the trade front and its threat to growth compared to last year is that central banks are more dovish. And this was underlined in the past week by both the ECB and the Fed sounding very dovish and looking to be preparing for monetary easing in the months ahead. ECB President Draghi noted that “in the absence of improvement..additional stimulus will be required” and the Fed was dovish across the board in downgrading its activity assessment, inflation expectations and dot plot of Fed officials’ interest rate view. Both look likely to start easing around July/September. While shares are still vulnerable to a short-term pull back in the months ahead on weak data, trade uncertainties or Middle East tensions, investors who bet against the ECB and the Fed over the last decade would have made a big mistake. And the same likely applies now, with global growth and shares likely to be higher on a 6-12 month view.
It’s hard to see the Fed easing more than the RBA. Current market pricing is for around 100 basis points of Fed cuts over the next 12 months compared to around 60 basis points from the RBA. Our view is that the US economy is not that bad and it’s more likely to be around 50 basis points from the Fed. Growth in the US is running at 3.2% year-on-year compared to 1.8% in Australia, unemployment plus underemployment is 7.1% in the US compared to 13.7% in Australia, job separations or quits are at a cyclical high in the US compared to a multi-decade low in Australia and there are less unemployed people than vacancies in the US compared to 2.5 times more in Australia.
Australian shares are now just 2 or 3% away from their resources boom high reached on 1 November 2007. While US shares made it back to their 2007 high in 2013 and global shares did the same in 2014, Australian shares took longer because of much higher interest rates after the GFC, the absence of money printing, the high A$ until recent years, the collapse in commodity prices and the fact that the 2007 high was a much higher high for Australian shares than it was for global shares. The fact that Australian companies provide more of their return in dividends – with a dividend yield of 4.5% compared to around 2.5% for global shares – means we really need to assess them including dividends, i.e. with an accumulation index, and on this basis the Australian share market surpassed its 2007 record high way back in 2013.
Is it sustainable? In the short term who knows! Going through past bull market highs after a long period below can attract investors into the market because of all the attention it causes so it could push on for a bit. But after such a huge run – the market is up 18% year-to-date and 6% since around the election – it is getting vulnerable to a technical pull back, and soft economic data, global trade uncertainty or geopolitical threats could provide the trigger. However, looking beyond the short term, the combination of low bond yields, easing central banks and a likely pick up in global growth in the second half point to even higher share prices on a 6-12 month horizon.
On something very different.. clearly 'The Pet Shop Boys' are not great fans of some politicians but seeing this makes me wonder how come I never get a welcome like that? - although things didn’t end so well for the Ceausescu’s nearly 20 years later! I wouldn’t mind one of those Lincolns though!
Major global economic events and implications
US economic data released over the last week was a mixed bag. Headline manufacturing conditions indexes in the New York and Philadelphia regions fell sharply and business conditions PMIs weakened slightly further in June, all suggesting trade and other uncertainties are continuing to impact. However, at least the components of the Philadelphia survey held up pretty well. Meanwhile housing starts and home sales are showing signs of responding to falling mortgage rates.
Eurozone business conditions PMIs remained well down from their highs of 18 months ago but edged up a bit in June, continuing to suggest that worst of the slowdown may be over.
While the ECB and Fed swung dovish big time, the Bank of Japan seemed more relaxed…for now. The pressure remains on though given ongoing weak core inflation of 0.5% in May and a soft manufacturing PMI reading. The Bank of England was a bit more dovish though.
Australian economic events and implications
Australian data releases were pretty lightweight over the past week. ABS house prices confirmed a roughly 3% fall in house prices for the March quarter but this was long ago reported by private sector surveys which have since shown a moderation and post the election a stalling in house price falls. Continuing strong population growth of 1.6% over the year to December quarter last year (led by Victoria at 2.2% year-on-year, Queensland at 1.8% and NSW around average) highlights an underlying source of strong demand growth in the economy including for housing. But a fifth fall in a row in skilled vacancies in May highlighted slowing jobs growth ahead and probably a further upwards drift in unemployment which we expect to reach 5.5% by year-end and which will act as a constraint on property price increases. CBA’s business conditions PMIs rose further in June suggesting news of rate cuts may have helped.
The minutes from the last RBA board meeting and a speech by RBA Governor Lowe reiterated the RBA’s key messages of late: that there is still spare capacity in the labour market; more rate cuts are likely; but help from fiscal policy is desirable. We remain of the view the RBA will in July/August, November and February taking the cash rate to 0.5%.
There was good news on the fiscal front with a further lift in infrastructure spending in NSW and SA such that public capital spending will continue to grow at around 10% over the year ahead. This is good as infrastructure spending growth needs to remain strong for a while yet to help fill the gap from the housing downturn. We might need to see more though.
Meanwhile RBA Head of Financial Stability Jonathan Kearns provided a bit of balance around the issue of mortgage arrears – pointing out that they are rising but remain low on global comparisons and well down on early 1990s levels and that arrears amongst loans made after lending standards were tightening are lower than those made before. Unemployment remains the key though – it can go up a bit but if it goes up a lot (to say to 6.5%/7% plus then it could have a bad feedback impact on the housing market). Which I suspect is what the RBA is trying to head off!
What to watch over the next week?
The meeting between Presidents Trump and Xi at the G20 meeting on Friday and Saturday to try and restart trade talks will no doubt dominate over the week ahead.
A speech by Fed Chair Powell on Tuesday will be watched for any clues regarding US interest rates. On the data front in the US, the main focus is likely to be on core private consumption deflator inflation for May to be released Friday which is likely to show a fall to just 1.5% year-on-year. In other data, expect a slight fall back in consumer confidence, a rise in new home sales and modest gains in home prices (all Tuesday), a modest rise in underlying durable goods orders (Wednesday) and a small rise in pending home sales (Thursday).
Eurozone economic sentiment data for June (Thursday) will be watched for further signs of stabilisation after the fall through last year and core inflation for June (Friday) is likely to have remained weak at around 0.8% year-on-year.
Japanese labour market data for May to be released Friday is likely to remain tight, helped by the falling population and industrial production data will also be released.
In Australia, RBA Governor Lowe is on a panel discussion on Monday, but I doubt he can tell us much more that is new in terms of the interest rate outlook. Private credit growth for May (Friday) is likely to have remained modest.
Outlook for investment markets
Share markets remain vulnerable to short term volatility and weakness on the back of uncertainty about trade, Middle East tensions and mixed economic data. But valuations are okay – particularly against low interest rates, global growth is expected to improve into the second half if the trade issue is resolved and monetary and fiscal policy has become more supportive and will likely become even more so all of which should support decent gains for share markets over the next 6-12 months.
Low yields are likely to see low returns from bonds, but government bonds remain excellent portfolio diversifiers.
Unlisted commercial property and infrastructure are likely to see reasonable returns. Although retail property is weak, lower for longer bond yields will help underpin unlisted asset valuations.
National average capital city house prices remain under pressure from tight credit, record supply and reduced foreign demand. However, the combination of rate cuts, support for first home buyers via the First Home Loan Deposit Scheme, the relaxation of the 7% mortgage rate test and the removal of the threat to negative gearing and the capital gains tax discount point to house prices bottoming out by year end and higher than we had been expecting. We see a 12% top to bottom fall in national capital city average prices. Next year is likely to see broadly flat prices as rising unemployment acts as a constraint.
Cash and bank deposits are likely to provide poor returns as the RBA cuts the official cash rate to 0.5% by early next year.
The A$ is likely to fall further to around US$0.65 this year as the gap between the RBA’s cash rate and the US Fed Funds rate will likely push further into negative territory as the RBA moves to cut rates by more than the Fed does. Excessive A$ short positions, high iron ore prices and Fed easing will help provide some support through and will likely prevent an A$ crash.