Don't Worry About Germany

Originally published by AMP Capital

Investment markets and key developments over the past week

• While Chinese shares fell 0.4% over the last week, US shares rose 0.9% helped by retailers and oil shares, Eurozone shares also gained 0.9%, Japanese shares rose 0.7% and Australian shares rose 0.4%. Bond yields were flat to down helped by ongoing concerns about low inflation in the US and this also weighed on the US dollar. Commodity prices rose and this along with a weaker US dollar and a reiteration of RBA Governor Lowe’s view that the next move in Australian interest rates will be up saw the Australian dollar rise.

• The failure of attempts to form a “Jamaica” coalition government in Germany over disagreements around immigration won’t threaten the German economy or the euro. The Social Democrats have indicated that they are open to talks on backing a Merkel led government and failing that another election will likely take place next year which could see support for Angela Merkel increase as Germans’ opt for stability. In the meantime, the German IFO business conditions index is at a record high, no major economic decisions are awaiting the formation of a new government and with over 80% of Germans supporting the euro there is no threat to its survival. Eurozone shares remain cheap and very attractive given improving growth & profits and a highly supportive ECB.

• In Australia, it’s no surprise to see the Government talking of tax cuts ahead of the next election but it’s doubtful this will change the outlook for the economy or interest rates over the year ahead. Tax cuts are expensive (a 1% across the board cut to marginal tax rates would cost around $7bn pa), but make some economic sense to the extent that the household sector is weak, the RBA is reluctant to cut interest rates again and it would return bracket creep. However, while they could be announced in the May budget next year: it’s unlikely they’ll commence until July 2019 so it will be a while before they impact; while the budget is currently running better than projected, budget savings would still likely have to be found to be confident of keeping the return to surplus for 2020-21 on track which will reduce their impact; and they will be further offset by the July 2019 0.5% increase in the Medicare levy.

• Finally, it’s been another sad week for aging baby boomers with the death of Malcolm Young (the driving force behind ACDC) and David Cassidy. After The Brady Bunch, The Partridge Family was one of my favourite TV shows. A few years ago I watched virtually all the episodes of both series with my children, which at one point led to a debate between my son and daughter as to which was the best show – my daughter way preferred The Partridge Family because while both shows were made around the same time Shirley Partridge was a liberated women running a business and raising a family in contrast to Carol Brady. Anyway it’s sad to hear David Cassidy has now passed away and had difficult times later in life a bit like his father. But his & The Partridge Family’s music lives on.

Major global economic events and implications

• US data remains strong. While lower aircraft orders pulled durable goods orders down in October, core investment orders remain in a solid rising trend pointing to stronger business investment. Meanwhile consumer sentiment remains around its highest since 2000, existing home sales rose more than expected, business conditions PMIs fell slightly but remain strong and jobless claims remain ultra low.

• While the minutes from the Fed’s last meeting and comments by Fed Chair Yellen highlight ongoing concerns about low inflation our view remains that disappearing spare capacity and the very tight US labour market will see core inflation head up towards the 2% target next year but it (and Fed rate hikes) will be gradual and we will remain in the “sweet spot” of the cycle (good growth/low inflation/benign central banks) for a while yet which is positive for shares. In the meantime, the Fed is on track for a December hike.

• Eurozone business conditions PMIs rose further in November and are near as high as they ever get. Consumer sentiment also rose to a 20-year high. Very strong business and consumer sentiment point to further growth acceleration. In fact, based on business conditions readings and inflation the Eurozone is in an even better “sweet spot” than the US.

• China saw another restructuring move with average import tariffs across a range of consumer goods to fall from 17.3% to 7.7%, providing a further boost to consumer spending and sending another signal its committed to free trade.

Australian economic events and implications

• In Australia, construction data for the September quarter surged for the second quarter in a row sparking excitement that maybe an investment boom has arrived. But yet again it was due to a distortion associated with the installation of imported LNG equipment, so alas there won’t be any big flow through to GDP growth. Dwelling construction was also soft but private non-residential building rose adding to signs non-mining investment is on the mend and public construction continues to surge on the back of the infrastructure boom.

• Nothing really new from the RBA. The minutes from the RBA’s last board meeting were consistent with recent messages from the Bank: it remains confident that growth will pick up and that this will eventually boost growth in wages and inflation resulting in the next move in interest rates being up, but for now rates will remain on hold. While growth is likely to improve a bit, high underemployment, very low wages growth, the disinflationary impact of technological innovation (with Amazon's (NASDAQ:AMZN) expanded arrival in Australia likely to take 0.2% or so off inflation in 2018), below target underlying inflation and the risk that the Australian dollar will remain too high mean that the RBA won’t be able to raise interest rates anytime soon. So our view remains that rates will be on hold out to the end of 2018 at least and it may be well into 2019 before rates start to rise. Meanwhile, the risk of another rate cut remains.

• Meanwhile, with the housing market in Sydney and to a lesser extent Melbourne slowing, APRA has indicated its now looking into how banks assess living expenses and the total debt of borrowers. After the focus on slowing lending to investors and interest only borrowers this could be the next leg in an ongoing tightening in lending standards adding to the likelihood that the housing market won’t simply bounce back again next year, like it did in 2016 after slowing in 2015 after APRA’s first round of tightening measures.

What to watch over the next week?

• In the US, the focus is likely to be a Senate vote on its tax reform bill. The GOP has 52 senators out of 100 so can only afford to lose two senators and still pass the bill with the Vice President’s casting vote. After more tweaks around contentious issues, we think it will pass – but it will clearly be close. Meanwhile, key data is likely to point to a slight lift inflation and continuing strength in business conditions. On Thursday the Fed’s preferred inflation measure, the core private consumption deflator is likely to show a slight lift in inflation to 1.4% year on year and on Friday the ISM manufacturing conditions index is likely to show that business conditions remain robust with a reading around 58.4. In other data expect to see a pullback in new home sales (Monday), continued gains in home prices and ongoing strength in consumer confidence (both due Tuesday), a rise in pending home sales and an upwards revision to September quarter GDP growth to 3.2% (both Wednesday) and a solid rise in personal spending for October (Thursday). Fed Chair Janet Yellen will deliver a speech that will no doubt be watched for any clues on US interest rates (both Wednesday).

• In the Eurozone, expect economic confidence for November (Wednesday) to remain strong, unemployment for October to fall to 8.8% but core inflation for November to rise to just 1% year on year (both Thursday).

• In Japan, expect industrial production (Thursday) to bounce back, and data on Friday to show a modest rise in household spending, a slight improvement in household spending and a slight rise in core inflation to 0.3% year on year.

• Chinese manufacturing conditions PMIs (due Thursday and Friday) are likely to remain solid at around 51-52 and the non-manufacturing conditions PMI is expected to remain around 54.

• OPEC’s meeting on Thursday will be watched closely with an extension in production cuts beyond their current expiry of March next year likely to be announced. If not, expect a sharp fall back in oil prices which have partly run up in anticipation.

• In Australia, the key focus will be on September quarter business investment data (Thursday) which will provide an input in GDP estimates and a guide to the investment outlook. Expect a slight gain in business investment reflecting stronger non-residential building and a slight upgrade to the outlook for non-mining investment plans. Meanwhile expect continued moderate growth in credit and a 2.5% decline in building approvals (both Thursday) and CoreLogic data for November to show a further slowing in national home price growth (Friday) with further falls in prices in Sydney.

Outlook for markets

• While the risk of a decent correction in global share markets is high (particularly given the risks around US tax reform and the December 8 debt ceiling and government shutdown deadlines), we are now in a favourable part of the year for shares seasonally and remain in a sweet spot in the investment cycle – with okay valuations particularly outside of the US, solid global growth and improving profits but still benign monetary conditions. So we remain of the view that the broad trend in share markets will remain up. Australian shares are correcting their recent break above the 6000 level, but are likely to continue to participate in the global share rally albeit remaining a relative laggard thanks to a more constrained earnings outlook.

• Low starting point government bond yields and a likely rising trend in yields will likely drive poor returns from bonds.

• Unlisted commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this will wane eventually as bond yields trend higher.

• The Sydney and Melbourne residential property markets are likely to slow further over the next year or two with prices likely to fall by around 5-10%.But Perth and Darwin are likely close to the bottom, Hobart is likely to remain strong and moderate price gains are expected to continue in Adelaide and Brisbane.

• Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.25%.

• Expect the Australian dollar to fall to around $US0.70. With the RBA on hold for the next year or more and the Fed on track to hike in December with another three or more hikes next year the interest rate differential will continue to move against Australia which should result in further weakness in the Australian dollar.

• Eurozone shares gained 0.2% on Friday as did the US S&P 500 helped by post Thanksgiving retail optimism and higher oil shares. S&P/ASX 200 futures fell 1 point though pointing to a flattish start to trade Monday. Given the positive global lead and gains in commodity prices I suspect the open is more likely to be positive.