Shares were mixed over the last week with US and Chinese shares up, but renewed Brexit fears weighing on Eurozone shares, disappointment at the lack of fiscal easing just yet weighing on Japanese shares and Australian shares being weighed down by a fall in the iron ore price and worries that stronger than expected GDP growth means reduced prospects for RBA rate cuts. Metal prices fell slightly but oil was little changed despite OPEC failing to agree to a production target, the $A rose slightly and bond yields in major countries fell.
Looks like I was too soon to speak of diminishing Brexit risk a week ago with the latest round of polls seeing support for the “Remain” and “Leave” options converging again. Here are some key points on the June 23 Brexit vote:
First, even if there is majority support to Leave it could be two years or so before the terms of the exit are agreed.
Second, a victory for Leave would be seen as a negative for the UK given the threat it would pose to its access to EU markets, its financial sector and labour mobility. The size of this impact would depend on what sort of exit is negotiated with the EU but has been estimated at somewhere around -2% of UK GDP. This would adversely affect UK assets including the pound. Britain could in time agree a trade deal with the EU (like Norway has) but this would involve a loss of sovereignty as Britain would have to agree to EU rules with no say in setting them.
Third, the real issue (given the diminishing significance of the UK economy) would be perceptions of the impact on the Eurozone. A Brexit would not be of the same order as a Grexit because Britain is not in the Eurozone. But it could lead to renewed concerns about the durability of the Euro to the extent that it may be seen as encouraging moves within Eurozone countries to exit the EU and Eurozone (eg, a Frexit) which in turn could reignite concerns about the credit worthiness of debt issued by peripheral countries, lead to a flight to safety out of the Euro into the $US which could in turn put renewed pressure on emerging market currencies, the Renminbi and commodity prices. All of which could trigger a bout of nervousness in global financial markets. Ultimately, the latter seems unlikely though as it would more likely trigger more pressure for integration in the Eurozone. Markets won’t know that initially though.
Fourth, a Leave victory may be seen as reinforcing the anti-globalisation forces already evident globally.
Fifth, while this sounds negative a Brexit has been subject to constant debate lately and is seen as the biggest “tail risk” by fund managers according to a recent survey, so it should be at least partly allowed for.
Sixth, Brexit uncertainty argues strongly in favour of the Fed delaying any rate hike until July if it wants to avoid being seen as reckless. Key Fed officials recognise this.
Finally, while the polls show the vote is close, it is notable that the Remain vote has had the edge over time and my assessment is that a majority of British voters will chose to stick with the status quo, much like the Scots did last year. So I attach a 70% probability in favour of Remain.
Has China really overinvested? This seems to be taken as a given and then used to justify a bearish for ever view on commodity demand, comparisons to Japan, etc. But I am still a bit sceptical. Two things have particularly added to my scepticism lately. First, if the Chinese housing market really saw a massive over supply of housing with ghost cities etc then why do Chinese property prices take off every time the regulators take the brakes off? Soufun’s 100 city property price index rose 1.7% in May and is now up 10.3% yoy. Second, the following stats on the number of airports in each country caught my eye: the US 13,513; Canada 1467; Russia 1218; Germany 539; Australia 480 (must include little ones); China 507. Not much sign of an overinvestment in China here! And I suspect the same applies in relation to much of China’s infrastructure.
Australia’s minimum wage to rise 2.4% to $17.70/hour, but it’s unlikely to have much macro impact as it only affects 15% or less of the workforce so won’t affect overall wages growth much. Last year’s rise was 2.5% and yet overall wages growth still slowed to 2.1% year on year. While Australia’s minimum wage in US dollar terms was way above OECD country norms when the $A was above parity, the 30% plus plunge in the $A means it’s not as much of an issue now from a global competitiveness point of view. Having a relatively high minimum wage compared to say the US is one reason why unemployment is higher in Australia versus the US, but then it does have some benefits from a social equity point of view.
Major global economic events and implications
US data was mostly favourable with a increased consumer spending in April, continued gains in home prices, a surprise rise in the May manufacturing conditions ISM index, solid jobs data and stronger than expected auto sales. However, construction spending and consumer confidence were softer than expected. Meanwhile, the Fed’s preferred inflation measure, the core private final consumption deflator was unchanged at 1.6% year on year in April compared to its 2% target and the Fed’s Beige book observed “modest” economic and wages growth and “slight” price rises.
As expected the ECB remained in implementation and assessment mode at its June meeting, but the ECB’s continuing sub target inflation forecasts (1.6% for 2018) and President Draghi’s dovish comments indicate it retains an easing bias. Eurozone economic confidence improved for the second month in a row remains at levels consistent with continued okay economic growth, unemployment remained high at 10.2% and bank lending continued to increase modestly. Meanwhile inflation ticked up slightly but core inflation at 0.8% yoy remains well below target.
As widely expected, Japanese PM Abe has delayed the scheduled second increase in its GST rate to October 2019, with “bold” fiscal stimulus likely to be announced in the months ahead. Meanwhile, labour market data for April was solid and industrial production rose but it’s still trending down on a year ago and household spending remains weak.
Chinese May business conditions PMIs were flat or down slightly and remain up on recent lows telling us that GDP growth is continuing to run along between 6.5-7%.
India remains a star performer globally with GDP up 7.9% over the year to the March quarter.
Australian economic events and implications
Australian data released over the last week was mostly strong with GDP much stronger than expected and up 3.1% year on year, building approvals rebounding back towards record levels, house price momentum picking up again led by Sydney, okay retail sales growth and the trade deficit continuing to contract. However, there were some soft numbers though with a fall in new home sales and mixed PMIs for May.
The bottom line is that thanks to a combination of booming resource exports as various projects complete (the third phase of the mining boom) along with a rebalancing of the economy towards consumer spending, housing and services the economy is a long way from the much feared recession and there is no sign of one on the horizon.
However, there are some dampeners: demand growth in the economy remains very weak with private final demand virtually flat; surging resource export volumes won’t create many jobs; nominal growth in the economy (at 2.1% yoy) is very weak reflecting the commodity price slump and very low inflation; this in turn is weighing on profits; and meanwhile the seeming return to boom conditions in the Sydney and Melbourne property market and another spike in apartment approvals poses an increasing risk of a property bust down the track.
Overall, our conclusion is that given the various cross currents the RBA won’t be rushing into another rate cut in the months ahead but will cut again later this year. Meanwhile, if the renewed strength in home prices isn’t temporary expect a renewed round of APRA measures to slow mortgage lending.
What to watch over the next week?
In the US, a speech by Fed Chair Janet Yellen on Monday is likely to repeat her comment from a week ago that if economic data unfolds as the Fed expects then a rate hike is likely to be appropriate in the “coming months” without being committal as to whether she favours June or July, but that it will remain cautious and conscious of the risks. Our assessment remains that the risks around the June 23 Brexit vote and a desire to better assess whether the recent bounce in US data is sustainable will see the Fed wait till July but it remains a close call. US data on job openings (Wednesday) and consumer sentiment (Friday) will also be released.
China’s data for May will start to be released with exports and imports (Wednesday) likely to show a slight improvement and inflation data (Thursday) likely to show a further abatement of producer price deflation but CPI inflation remaining around 2.3% year on year. Credit data is expected to show a pick up from the softness seen in April.
Interest rates will again be the focus in Australia, with the RBA meeting Tuesday and likely to leave them on hold. While lower than expected wages growth for the March quarter and a still too high Australian dollar support the case for another rate cut to combat downside risks to inflation, solid real economic growth and the RBA’s desire for “further information” after cutting last month is likely to see the RBA wait till August before cutting rates again. Meanwhile, expect ANZ job ads (Monday) to point to a softening trend for jobs growth but housing finance for April (Wednesday) to show a 3% rise.
Outlook for markets
Significant event risk in the next month or so (Fed meeting, Brexit vote, Spanish election, Australian election) and the fear of “sell in May and go away, come back on St Leger’s Day” could drive an increase in short term share market volatility. However, beyond near term volatility, we still see shares trending higher this year helped by a combination of relatively attractive valuations, ultra easy global monetary conditions and continuing moderate global economic growth.
Very low bond yields point to a soft medium term return potential from them, but it’s hard to get bearish in a world of fragile growth, spare capacity and low inflation.
Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors.
Capital city residential property price gains are expected to slow to around 3% this year, as the heat comes out of Sydney and Melbourne. Prices are likely to continue to fall in Perth and Darwin, but price growth is likely to pick up in Brisbane.
Cash and bank deposits offer poor returns.
After its recent fall from $US0.78 the $A is technically oversold and due for a bounce. However, any bounce is likely to be limited and the longer term downtrend looks to be resuming as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed resumes hiking, commodity prices remain in a secular downswing and the $A sees its usual undershoot of fair value.