28 October 2016
Shares were mixed over the last week with Japanese shares up 2.0% and Chinese shares up 0.4%, but Eurozone shares flat, US shares down 0.7% and Australian shares down 2.7%. US shares were hit late on Friday by renewed election uncertainty, as the FBI announced it was reopening its investigation into Hillary Clinton’s use of a private email server while Secretary of State. Bond yields continued to back up as prospects for a December rate hike by the US Federal Reserve (Fed) continue to firm and as stronger UK growth diminished prospects for a further Bank of England easing. Commodity prices were mixed with oil down but metals up. The A$ fell slightly despite a fall in the US$.
Why the recent poor performance from Australian shares? While global shares have been range bound over the last few months, with Eurozone and Japanese shares benefiting from falls in their currencies and the US share market down a bit, Australian shares are down 5% from their August high. This relative underperformance reflects a combination of four factors. Firstly, there are concerns about the Fed and the US election that seem to be weighing on most share markets at present. Secondly, there is a reversal of the huge bond rally that had helped the higher dividend paying Australian share market and sectors like real estate investment trusts up to mid-year. Thirdly, a soft patch in consumer spending is weighing on retailers. Fourthly, stock specific issues are at play. Of these, the turn up in bond yields is perhaps most significant, taking a huge toll on defensive high yield sectors like REITs. With the Fed on track to hike again in December, and the Reserve Bank of Australia (RBA) likely to be on hold for now, a further back up in bond yields is likely into December. However, while the bull market in bonds is likely over as global inflation bottoms, the back up in yields generally is likely to be gradual as global growth is set to remain constrained, the Fed is likely to remain gradual in raising interest rates and other major central banks including the RBA are likely to either remain on hold or biased to easing further. Meanwhile, defensive yield sectors are getting very oversold and are due for a bounce, while cyclical sectors have more upside if, as we expect, global and Australian economies continue to see moderate growth. Bottom line – it’s just another correction.
Spain moving out of limbo with the focus shifting to Italy. The political impasse that has hung over Spain following inconclusive elections in December and June looks likely to be resolved with the Socialist party voting to a abstain from voting in a parliamentary confidence vote. This would see Mariano Rajoy confirmed as Prime Minister. However, political risk in Europe has shifted to Italy and Austria. Italy will hold a referendum on December 4 to decide on reducing the power of its Senate. Prime Minister Matteo Renzi is seeking to achieve this in order to proceed with economic reform, something Australia should maybe think about! Mr Renzi is threatening to resign if the referendum proposal is not passed, which would then provide a boost to the mostly anti-Euro Five Star Movement. On the same day, Austria will hold a re-run of its presidential election, with the far right candidate being anti-Euro. So if these two votes go the wrong way, we could see another bout of Eurozone break up fears. Either way, I remain of the view that the Eurozone will continue to hang together, as mainland Europeans are far more attached to the European Union (EU) and Eurozone concept than the UK ever was. Much of the recent rise in populism in Europe is really a backlash against austerity, rather than against the Euro, which remains popular. What’s more, European shares remain very undervalued.
Based on history the best outcome for US shares will be a Clinton victory but with the Republicans retaining control of at least the House of Representatives. Since 1927, US total share returns have been strongest at an average 16.7% pa when there has been a Democrat president and Republican control of the House, the Senate or both. By contrast the return has only averaged 8.9% pa when the Republicans controlled the Presidency and Congress.
Source: Bloomberg, AMP Capital
A Trump victory would likely trigger an initial bout of ‘risk off’ with shares down (both in the US and globally), bonds rallying and the US$ up as investors fret about his economic policies, particularly the possibility of his protectionist trade policies triggering a global trade war. Australian shares and the A$ would be particularly vulnerable to this, given our high trade exposure. But a Clinton/Democrat clean sweep of the Presidency and Congress would likely also trigger a bout of nervousness in US shares, as it would be easier for Clinton to implement less business-friendly tax and regulatory policies that would weigh on US health, energy and financial stocks. This would likely be more focussed on US shares though, with less of an impact on global and Australian shares. The best outcome for shares would be a Clinton victory but with Republicans retaining control of at least the House as this would be seen as more of the same. While Clinton was ahead in the latest polls by an average 5.2 points these were taken before the FBI reopened an investigation into her use of a private email server while Secretary of State, which adds to uncertainty going into the final week of the election campaign. In any case, there is no sign of a wave of support going towards the Democrats that will see them win the 30 seats necessary to take the House.
Major global economic events and implication
US data was mostly good. Manufacturing and services conditions PMIs are up solidly, home sales are strong, home prices continue to rise and unemployment claims remain low. September quarter GDP growth accelerated to 2.9% annualised. This occurred as the inventory cycle turned and trade contributed strongly to growth, offsetting softer growth in consumer spending. However, durable goods orders are trending sideways and consumer confidence fell, but this looks to be related to election uncertainty. This is all consistent with a December rate hike, assuming a Clinton victory. But continued soft wages growth, with the Employment Cost Index up only 2.3% yoy in the September quarter, and constrained economic growth will likely keep the Fed on a gradual tightening path through 2017.
Despite a few high profile misses, the US September quarter profit reporting season is actually looking pretty good…the profit recession looks to have ended. Of the 299 S&P 500 companies to report so far, 78% have beaten earnings expectations and 59% have exceeded sales estimates. Profits are now expected to be up 4% on the June quarter and up 15% from their March quarter low. Further, they are expected to surpass their 2014 high. A 4% yoy gain in revenue is a key driver.
Eurozone business conditions PMIs also rose strongly in October, as did economic confidence, pointing to continued moderate growth.
Japanese data was also solid, with stronger manufacturing conditions, a rise in small business confidence, an improvement in household spending and solid labour market indicators. However, deflation continued in September, with core inflation falling to zero.
Chinese industrial profits slowed in September to 7.7% yoy, but consumer confidence spiked in October.
Australian economic events and implications
Inflation remains very low, but maybe not low enough to trigger another RBA rate cut just yet. September quarter CPI inflation at 0.7% qoq was a bit higher than expected. This was mainly due to prices for fruit & vegetables, electricity, tobacco and property rates. Underlying inflation at 0.3% qoq was a bit lower than expected, with ongoing evidence that deflationary pressures are still working through the economy. On balance it is probably not enough to trigger an immediate rate cut, as inflation is in line with the RBA’s own expectations, economic growth looks to be reasonable and rising commodity prices are set to boost national income. The latter was reflected in the second rise in the goods terms of trade in row in the September quarter. A further rise is likely in the December quarter, as higher coal and iron ore prices feed through. Meanwhile, new home sales rose again in September and remain strong, while producer price inflation remains very low.
What to watch over the next week?
In the US, the Fed (Wednesday) is very unlikely to raise interest rates particularly with a ‘risky’ election just six days later but the post meeting statement is likely to confirm that it is on track to raise rates in mid-December (the market probability is just 17% for a November hike and 69% for a December hike). Meanwhile, September quarter earnings reports will continue to flow with around 100 S&P 500 companies due to report. The October ISM manufacturing conditions Index (Tuesday) is likely to show a further improvement, and monthly jobs data (Friday) is expected to show continued solid jobs growth of around 170,000, a slight fall in the unemployment rate to 4.9% but continued modest wages growth. Meanwhile, core inflation according to the private consumption deflator (Monday) is likely to have remained unchanged at 1.7% yoy in September.
In the Eurozone, September quarter GDP data (Monday) is expected to show continued moderate growth. Expect a further rise in October CPI inflation (Monday) as the fall in oil prices from a year ago drops out, but core inflation should remain around 0.8% yoy.
Japanese industrial production for September (Monday) is expected to show continued growth and the Bank of Japan (Tuesday) is unlikely to make any changes to monetary policy after the further easing announced a month or so ago.
Chinese manufacturing conditions’ PMIs for October (Tuesday) are likely to pause or slow slightly, but should remain consistent with a stabilisation in growth.
In Australia, it’s a close call but the RBA is expected to leave interest rates on hold at its monthly Board meeting (Tuesday). September quarter inflation was low on an underlying basis, but probably not low enough to trigger another cut just yet as it is in line with the RBA’s own expectations. Economic growth in Australia looks reasonable with the worst of the mining investment slump behind us and a rise in commodity prices starting to boost national income again. As such, the RBA can afford to be patient in waiting for inflation to head back to target, and thereby avoid the risk of adding to financial instability (read a further acceleration in Sydney and Melbourne home price gains) with another rate cut for now. Overall, we think that the RBA will leave rates on hold at its Melbourne Cup Day meeting, but with inflation remaining very low, the AA still uncomfortably high and jobs data softening lately, it is premature to close the door on another rate cut, although that’s more likely to be a 2017 story. The RBA’s Statement on Monetary Policy (Friday) will likely see little change to their growth and inflation forecasts.
On the data front, expect credit growth (Monday) to remain moderate, CoreLogic home price growth (Tuesday) to remain solid and building approvals (Wednesday) to fall 6%. The trade deficit (Thursday) should show a further decline as higher coal prices flow through, and retail sales (Friday) should grow 0.2% in September but just 0.1% in the September quarter in real terms.
Outlook for markets
We remain cautious on shares in the short term as event risk is high for the months ahead. Risk factors include ongoing debate around the Fed and ECB, the US election on November 8, the Italian Senate referendum and the Austrian presidential election re-run (both on December 4). Bond yields could also see more upside in the short term. However, after any short term weakness, we anticipate shares to trend higher over the next 6-12 months helped by okay valuations, continuing accommodative global monetary conditions, moderate economic growth and the shift from falling to rising profits for both the US and Australian share markets.
Still ultra-low bond yields point to a poor medium term return potential from them, but it’s hard to get too bearish on bonds in a world of fragile growth, spare capacity, low inflation and ongoing shocks.
Commercial property and infrastructure are likely to continue benefiting from the ongoing search for yield by investors.
Dwelling price gains are expected to slow, as the heat comes out of Sydney and Melbourne thanks to poor affordability and tougher lending standards. Moreover, apartment supply should ramp up, which is expected to drive 15-20% price falls for units in oversupplied areas around 2018.
Cash and bank deposits offer poor returns.
The outlook for the A$ has become murky. 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 A$ remain downward. It normally overshoots on the downside after the bursting of commodity price booms, and this remains our base case. But against this, the stabilisation and rising trend in some commodity prices, and the continued gradual nature of Fed rate hikes, suggest ongoing upside risks in the short term. The danger is that the latter will threaten the rebalancing of the economy. The best defence against this is for the RBA to revert to a clear easing bias even if it never acts on it.
Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.