Outlook Markets continue to be driven by easy monetary conditions globally. Low interest rates are creating reasonably benign economic conditions with steady but unspectacular growth helping to narrow output gaps in developed economies. Central banks have shifted towards tightening policy, but this is a very gradual process and is creating an environment where equity markets are grinding higher.
Cyclical indicators continue to improve in developed markets, particularly in Europe, but the US is also solid. The US Federal Reserve is leading the shift to tighter policy with several rate hikes and beginning communication around balance sheet reduction. The ECB is only now starting to shift its rhetoric. After a significant broadening of the economic recovery, the ECB has shifted from an easing bias and at some stage this year are likely to step away from negative rates and wind back bond purchases. Escalating political tensions around North Korea’s nuclear missile program and the impact of major hurricanes on the US have seen a rise in risk aversion and bond yields move back towards recent lows. These risks are very material, but at odds with improving economic data.
As economic growth has improved across China, the policy focus has shifted from growth stability to financial stability. Infrastructure spending and supply side reform are likely to remain key features of the Chinese economy although growth risks are more balanced. Fiscal stimulus to support economic growth is likely to remain, but the demand side for bulk commodities is capped. We see more upside in aluminium and alumina if production cuts take place and there is also more upside in base metals such as copper and nickel. The increasing adoption of electric vehicles is also driving demand for new energy materials.
Another aspect of China’s supply side reform and renewed focus on environmental policy is a rise in domestic inflation. Both the core producer price and consumer price indices are pushing higher and this is being reflected in the increased price of manufactured exports. This is also showing up in increasing US import prices. Globalisation and the shift of manufacturing to low cost China has been the most significant driver of lower inflation in advanced economies in recent decades. The end of this dynamic is at least as powerful as the less well defined impacts of technology and ageing demographics. Complacency around inflation is at an extreme and while we don’t expect a huge breakout, even a small shift higher could trigger a faster normalisation of excessively accommodative monetary policy by developed market central banks. This would obviously reinforce pressure on bond yields and favour a cyclical rotation.
The domestic growth outlook is deteriorating. There is stronger evidence that the housing cycle has peaked and this is likely to be reinforced by APRA’s efforts to rein in aggressive mortgage lending. A heavily indebted household sector that is experiencing flat to negative real income growth as well as dealing with higher energy and healthcare costs and has drawn down its savings rate is unlikely to fill the gap in growth. Further downside risk to the economy may emerge if the current tightening in mortgage lending standards pushes house prices lower and generates negative equity effects. How this plays out remains uncertain as interest rates are at record lows, preventing much corporate sector stress and the currency remains a viable source of adjustment. State governments are effectively recycling stamp duty revenue into road and rail infrastructure which also provides some offset to activity.
In terms of portfolio positioning, we continue to maintain an underweight to interest rate sensitive sectors as the Fed moves to a more hawkish stance and the ECB approaches QE tapering. We are comfortable with the US growth profile and maintain overweight positions to US cyclicals and the cyclical recovery in Europe and emerging markets is also now strengthening. We are positioned towards metals and new energy materials over bulk commodities within the resources sector. Domestically, we are positioned more defensively in gaming, select industrials and a small overweight to banks. We are increasing the underweight to building materials, developers and retail as the housing cycle rolls over.
