Dr Shane Oliver
Head of Investment Strategy and Economics and Chief Economist
Investment markets and key developments over the past week
The past week saw US shares push to new record highs helped by good earnings results and Fed easing, but other share markets were soft not helped by mixed news on US/China trade talks and still soft global economic data. Increasing talk that the RBA may be done cutting saw the Australian share market fall led lower by financials, consumer and energy shares. Bond yields generally fell as did commodity prices with a sharp fall in the iron ore price. The Australian dollar rose as the Fed cut and as expectations for further RBA rate cuts were reduced.
The Fed cut rates by another 0.25% taking the Fed Funds rate to a range of 1.5-1.75% – but its likely now at or close to the low. This easing cycle has been all about taking out insurance against trade war uncertainty and weaker global growth adversely affecting the US economy – a bit Iike the Fed easings of 1987, 1995-96 and 1998. These were all just 0.75% which is what we have now seen so far this year. Rates could be cut further but there is a good chance that we are now at or close to the low for the Fed for this easing cycle: the latest trade truce between the US and China has a greater chance of success this time as President Trump wants to keep the US economy strong ahead of next year’s presidential election and wants good news in the face of the now formalised impeachment inquiry; US bond yields are up from their lows; the US yield curve is now positive across most maturities suggesting less risk of recession; European and Japanese shares are looking better; cyclical stocks like consumer discretionary, industrials and banks are looking better; and the US dollar looks like it might have peaked. These could be pointers to monetary easing in the US and globally starting to get traction. Low US and global rates are good news for shares and growth assets in the absence of recession, which we remain of the view is unlikely.
Another twist in the Brexit comedy with the UK on the way to a December 12 general election – the risk of no deal Brexit is low for now but it has gone up a bit. The EU has agreed another Brexit extension to January 31. In the near term a hard Brexit looks unlikely given the election choice between Johnson’s Brexit deal and probably a new referendum if Labour/Liberal Democrats win. But the vote is complicated by the hard-left policies of Corbyn’s Labour which may put some Remain voters off from voting for them and there is some risk of a no deal Brexit on January 31 if the Conservatives can only Govern with the Brexit Party. Of course, even if the election sees the UK ratify Johnson’s Brexit deal, the risk of an effective no deal Brexit will come up again later next year if the UK and EU can’t agree a a free trade deal.
While Australian inflation remained very low in the September quarter, its unlikely to have been weak enough to move the RBA to cut again in November so we have moved our expectation for the next rate cut to December. September quarter inflation was 1.7% year on year with the average of the core measures at 1.4% year on year. This was soft but looks unlikely to move the RBA to ease in November following recent comments by RBA Governor Lowe suggesting greater confidence in a “gentle upturn” in the economy and patience in getting inflation back to target all of which suggests the RBA is in little hurry to cut rates just yet.
However, we remain of the view that further RBA monetary easing will be required and is likely. Growth is likely to remain subdued and below trend for longer than the RBA is allowing. This will keep unemployment higher for longer and wages growth and inflation below target for longer. In fact, the RBA is likely to revise down yet again its growth and inflation forecasts when it releases its quarterly Statement on Monetary Policy on Friday. Consequently, more easing will be required to achieve full employment and clear progress to the inflation target. What’s more inflation has been running below target for more than four years now and the longer this is allowed to persist the more the inflation target will lose credibility and won’t be the “strong nominal anchor that people can rely on when making their decisions” as Lowe has stated the Board is seeking to provide. The perception that the RBA is now less inclined to ease further also risks pushing the Australia dollar higher, wiping out one transmission mechanism for monetary easing that the RBA can still rely on. The less dovish tilt the RBA has taken in October has already seen the $A rise by more than 3% which is a defacto monetary tightening and is the last thing the economy needs. So, in the absence of more fiscal stimulus, pressure remains on the RBA for further easing. We continue to see the cash rate being cut to a low of 0.25% but now see the timing as being December and February but this could also come with quantitative easing measures designed to lower bank funding costs and increase the banks’ pass through of rate cuts to borrowers. While a November rate cut looks unlikely, the collapse in the money market’s probability of a rate cut to just 6% for November and 24% for December looks over the top.
Major global economic events and implications
US data was mostly good. September quarter GDP growth was stronger than expected at 2% annualised thanks to strong consumer spending, consumer confidence remains solid along with consumer perceptions of the jobs market, pending home sales rose and jobs indicators were solid. Against this though manufacturing conditions fell sharply in the Chicago region. Core private consumption deflator inflation also fell back to 1.7%yoy leaving the Fed with a lot of flexibility and wages growth as measured by the employment cost index remains subdued at just 2.8%yoy (despite very low unemployment).
US September quarter earnings results remain reasonable. About 70% of S&P500 companies have now reported, with 80% beating earnings expectations (against a norm of 75%) by an average of 5.2% and 61% beating on sales. Earnings growth over the last year looks likely to end up with a small gain, but this is better than market expectations at the start of the reporting season which saw a 3% decline.
Eurozone September quarter GDP growth was soft at 0.2% quarter on quarter or 1.1% year on year but it was stronger than expected, it is still growing and with population growth around 0.2% pa it means per capita GDP growth is 0.9% which is stronger than in Australia (at -0.2%). In other data, economic confidence fell further in October, unemployment remained flat at 7.5% in September and core inflation for October rose slightly to 1.1%yoy but is in the same weak range its been in since 2017.
In Japan, industrial production bounced more than expected but tends to be volatile and Tokyo inflation showed very little acceleration in October despite the increase in the consumption tax from 8% to 10%. Meanwhile the Bank of Japan kept monetary policy on hold but strengthened forward guidance to state that it now expects rates to remain at current or even lower levels as long as it is necessary to avoid losing price momentum (whereas it used to be at least until spring 2020). This also suggests a strong easing bias.
China’s official PMI’s fell in October suggesting that economic growth remains under pressure which in turn adds to pressure for trade war de-escalation.
Australian economic events and implications
Australian economic data was a mixed bag. Home building approvals rose in September, but this was due to a bounce in volatile unit approvals with the fall in dwelling approvals over the last year pointing to further weakness in home building construction over the next six months or so. Fortunately, this will be partly offset by non-residential building where approvals have been trending up solidly and unit approvals look like they may be stabilising. Rising new home sales are also consistent with a stabilisation in home building approvals. Meanwhile credit growth slowed further in September with weakness across the board including housing investor credit, but credit data is lagging, includes debt paydowns and rising housing finance commitments point to stronger housing related credit growth in the next few months. Finally, the terms of trade rose again in the September quarter with a stronger than expected rise in export prices relative to import prices. This is good news for national income but the stronger rise in export prices means weaker than otherwise export volumes so net exports look like being a detractor from growth in the September quarter. There are so many cross currents in all this – but the bottom line seems to be that the economy is still growing but remains constrained.
On the inflation front, consumer price inflation remained weak in the September quarter as noted earlier, as did producer price inflation at just 1.6%yoy.
Finally, CoreLogic data for October showed a continuing rebound in home prices – led in particular by Melbourne and to a lesser degree Sydney but with most other cities also seeing decent gains. Quite clearly pent up demand unleashed by the election outcome, rate cuts and the lowering in APRA’s 7% interest rate serviceability test is continuing to impact. We have been off the view that after an initial bounce price gains would settle down to around 5%pa through next year but the risk is that the positive momentum is starting to feed on itself again pointing to continued strong gains into next year. For the time being the RBA is not too fussed as housing credit growth remains low – at just 3.1% over the year to September – but if house prices are to continue to surge this will see credit growth pick up too which will invite renewed regulatory controls on lending growth. But that’s a story for 2020.
What to watch over the next week?
In the US, expect data to be released Tuesday to show an improvement in the non-manufacturing business conditions ISM for October and a slight decline in September’s trade deficit. Data on job openings and hiring will be released the same day. September quarter corporate earnings results will also continue to flow.
Chinese trade data (Friday) is expected to show continuing softness in imports and exports. Consumer price inflation (Saturday) for October is expected to show a further lift in headline inflation thanks to swine flu, but core inflation is likely to remain soft at 1.5% year on year and producer price inflation is likely to remain negative.
In Australia, the Reserve Bank is likely to leave rates on hold at a record low of 0.75% at its board meeting on Tuesday. The RBA should be easing again given the long way the economy has to go to achieve full employment and to end the chronic undershooting of the inflation target but it looks reluctant to cut rates again just yet. Meanwhile, the RBA’s quarterly Statement of Monetary Policy (Friday) is likely to see yet another downgrade to its growth forecasts as June quarter GDP growth came in weaker than expected and its inflation forecasts for this year are also likely to be lowered again.
Meanwhile, on the data front in Australia September, retail sales to be released Monday will be watched closely for the long hoped for tax cut boost but are only likely to show a modest 0.3% gain consistent with industry feedback that only points to a mild boost. This is expected to have translated to a 0.2% rise in real retail sales for the September quarter as a whole which is only slightly better than the 0.2% gain seen in the June quarter. In other data expect to see a fall in the trade surplus (Thursday) and a further rise in housing finance commitments (Friday) of around 1.2%.
Outlook for investment markets
Share markets remain at risk of further short term volatility given issues around trade, Iran & the Middle East, impeachment noise and weak global economic data. But valuations are okay – particularly against low bond yields, global growth indicators are expected to improve by next year and monetary and fiscal policy are becoming more supportive all of which should support decent gains for share markets on a 6-12 month horizon.
Low yields are likely to see low returns from bonds once their yields bottom out, 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.
The election outcome, rate cuts, tax cuts and the removal of the 7% mortgage rate test are driving a rebound in national average capital city home prices led by Sydney and Melbourne. But beyond an initial bounce, home price gains are likely to be constrained through next year as lending standards remain tight, the record supply of units continues to impact and rising unemployment acts as a constraint. The risk though is that the recent surge in prices goes on for longer as property price gains in Australia have a habit of feeding on themselves.
Cash and bank deposits are likely to provide poor returns as the RBA cuts the official cash rate to 0.25% by early next year.
Our base case remains that the $A still has more downside to around $US0.65 as the RBA cuts rates further. However, with the US dollar looking like it may have peaked and given excessive $A short positions there is a growing risk that we may have already seen the bottom (at $US0.6671 early in October).
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