Investment markets and key developments over the past week
- The past week saw only modest gains in US, European and Japanese shares but a solid rise in Australian shares. The forces impacting global shares at present are mixed with shares overbought and due for a bit of profit taking and Italian bank woes impacting a bit in Europe, but mostly good economic data globally and positive seasonality (the so-called Santa rally). Chinese shares fell as Chinese policy tightening measures continued. Bond yields mostly fell, except in Australia where they rose a bit. The US dollar generally edged up and this along with lower prices for metals and iron ore saw the Australian dollar fall.
- 2016 turned out far better than feared by many at the start of the year with various political events just causing short term setbacks. Five key lessons from 2016 for investors are as follows:
- The Fed is not stupid – in setting interest rates it does take account of the strong US dollar (relevant for 2017 too) and the state of the world economy.
- China will not tolerate a rapid slowing in growth and movements in the Renminbi are more a strong US dollar story.
- A populist backlash against establishment politicians driven by issues such as inequality and immigration is underway with significant implications for economic policy – eg a retreat in globalisation. But…
- It remains best for investors to turn down the noise – fears that Brexit, Australia’s messy election, a Trump victory and an Italian “No” vote would lead to economic and financial catastrophe proved ill-founded. Retreating to cash after each of these events would have proved very costly in terms of foregone return potential.
- A key lesson for us was to stick to our investment process (fortunately we did) and not get blown around by swings in market sentiment. For many individual investors the best thing to have done in 2016 was to just stick to your long term investment strategy (as the global economy did not implode at the start of the year and political events like Brexit were just noise along the way).
- The past week reminded us that the terrorist threat remains – with a truck attack in Berlin and foiled attacks in Victoria. These acts of evil are horrible from a human perspective and they are likely to continue. But there was little significant impact on the German share market and financial markets seem to be getting used to such attacks and this is likely to remain the case in the absence of terrorism causing major economic disruption.
- It looks like the recapitalisation efforts of Italian banks including Monte dei Paschi di Siena have not been enough and that public support will be needed (and looks to be on the way). The key will be to avoid adversely affecting small individual bond holders in such banks as this will only boost support for the populist Five Star Movement.
- The Australian Government appears to have staved off a sovereign rating downgrade for now. While the Mid-Year Economic and Fiscal Outlook saw another $10 billion blow out in budget deficits over the period to 2019-20 it was broadly as expected and the Government is still projecting a return to a (wafer thin) surplus by 2020-21. However, some of the ratings agencies – S&P in particular – look very sceptical. I suspect that a ratings downgrade remains just a matter of time. While this would not necessarily lead to higher borrowing costs in the economy (many countries with lower ratings than Australia have lower borrowing costs and even if it adds 10-15 bps to bank funding costs this could be offset by an RBA rate cut) it would signal we have lost our way on the economic reform front.
- According to Government’s projections, Australia is now looking at 12 consecutive years of budget deficits totaling 26.8% of GDP compared to just 7 years totalling 17% of GDP in the 1990s – but back then we had our worst post war recession. Many things are driving the deficit blow out including past tax decisions and softer nominal growth but it’s interesting to note that the 16% surge in Government spending that occurred in 2008-09 has been sustained with average spending growth of 4.4% pa thereafter. The GFC surge in spending was justified in helping avoid recession…a big problem has been the failure to wind it back subsequently.
Major global economic events and implication
- US economic data was mostly strong with another upwards revision to September quarter GDP growth, another decent gain in underlying capital goods orders, okay consumer spending, the services conditions PMI remaining solid, existing home sales remaining strong and home prices continuing to rise. Interestingly inflation as measured by the core consumption deflator fell to 1.6% yoy supporting the case for the Fed to remain gradual for now in raising rates.
- The Bank of Japan unsurprisingly left monetary policy unchanged – its effectively on autopilot anyway basically committing in September to continue its asset buying program and keeping the 10 year bond yield at zero until it exceeds its 2% inflation target. And lately it seems to have run into a bit of good luck as this policy combined with expectations of tighter US monetary policy under a Trump presidency has helped push the Yen sharply lower which in turn has helped Japanese shares and exporters at a time when economic data has looked a bit better and nominal GDP has been revised back up to its late 1990s high. It seems for now at least that Japan has moved into a bit of a virtuous cycle…all of which is positive for Japanese shares which have managed to more than reverse a 21% year to date loss.
- Evidence continues to build that China is going through another one of its policy tightening phases – now that growth has stabilised and the focus has shifted back to slowing debt and home price growth. While the Government’s Central Economic Work Conference called for more proactive fiscal policy its tone also implied a slightly tighter monetary policy with the PBOC announcing more macro prudential tightening. However, stable growth likely remains the objective with a growth target for 2017 likely to be around 6.5%.
Australian economic events and implications
- The minutes from the last RBA meeting offered nothing new. The RBA is clearly having to balance the risk of a downwards price/wage spiral against the risks to household financial stability of ever lower interest rates. Our view remains that another downgrade to the RBA’s growth and inflation forecasts will see the RBA cut rates again in first half 2017.
What to watch over the next few weeks?
- In the US, the main focus in the next few weeks will be on the ISM manufacturing index (January 3) which is likely to remain solid, the minutes from the last Fed meeting (January 4) which are likely reinforce expectations for further rate hikes in 2017 and the December jobs report (January 6) which is likely to show continued solid jobs growth of around 180,000 and a rise in wages growth to 2.8% yoy but a slight bounce back in unemployment to 4.7% (from 4.6%). In other data expect to see a rise in consumer confidence and further home price gains (Dec 27).
- In the Eurozone, December inflation data (January 4) is likely to show a further rise in headline inflation to 0.9% year on year on the back of the rise in energy prices but core inflation remaining at 0.8% yoy. Economic confidence for December (January 6) is likely to have remained strong.
- Japanese jobs data for November is expected to have remained strong and headline inflation is expected to have risen to 0.5% yoy, but core consumer price inflation is expected to have remained around 0.2% yoy (all due December 27). Industrial production (December 28) is likely to show a decent bounce.
- Chinese manufacturing conditions PMIs for December (January 1 and 2) are likely to hang on to their recent gains.
- In Australia expect credit growth (January 30) to remain moderate, the December CoreLogic home price index (January 3) to show a further loss of momentum and the November trade deficit (January 6) to show a big improvement reflecting the lagged impact of higher bulk commodity prices.
Outlook for markets
- Shares are likely to see their traditional Santa Claus rally over the Christmas/New Year period. However, at some point in the first quarter a correction or consolidation in shares and the $US is likely as sentiment has become very stretched on the upside in relation to both and a bout of nervousness will no doubt kick in regarding what Donald Trump will do, US-China tensions and the negative impact of the rise in the US dollar. However, for 2017 as a whole our key themes are as follows:
- The combination of some acceleration in global growth, rising profits and still easy money at a time when investors remain highly sceptical (and ever fearful of the next GFC) should be positive for growth assets in 2017:
- Global shares are likely to trend higher and we favour Europe (which is cheap and likely to climb a wall of Eurozone break-up worries) and Japan (which will benefit from the lower Yen) over the US (which may be constrained after its 2016 outperformance and Fed rate hikes).
- Emerging markets may underperform if the $US continues to rise on Fed hikes but for now are looking attractive if as we expect the rise in the $US takes a break early in 2017.
- Australian shares are likely to have solid returns as resource sector profits surge following the rebound in bulk commodity prices, overall profits rise 10% and interest rates remain low. Expect the ASX 200 to return around 9% in 2017. In terms of sectors favour resources, retailers and banks.
- Bulk commodity prices are at risk of a short term pause/pull back but should remain well up from their 2015-16 lows.
- Still low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds. Australian bonds are preferred to global bonds as the back-up in Australian bond yields lately has run well ahead of what is justified given the outlook for RBA interest rate moves.
- Commercial property and infrastructure are likely to continue benefitting from the ongoing search by investors for yield, but this demand will wane as bond yields trend higher over the medium term.
- National capital city residential property price gains are expected to slow to around 3-4%, as the heat comes out of the Sydney and Melbourne markets and rising supply hits.
- Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.
- The downtrend in the Australian dollar from 2011 is likely to continue as the interest rate differential in favour of Australia narrows and it undertakes its usual undershoot of fair value. Expect a fall below $US0.70 but little change versus the Yen and Euro
Please feel free to give me a call if you wish to discuss.
This is our last weekly for 2016. I hope they have provided some value. All the best for a Merry Christmas (sorry I can’t bring myself to say “Happy Holidays” – it doesn’t work in Australia!) and I hope you have a happy New Year.