RBA Remains Too Optimistic But Heading For A Rate Cut

Originally published by AMP Capital

Investment markets and key developments over the past week

• Global shares were flat to down over the past week not helped by weak economic data and trade uncertainty. Australian shares saw a strong rise though as the banks saw a Royal Commission relief rally, the prospect of RBA rate cuts provided a boost to retailers, industrial stocks and yield sensitives and miners continued to benefit from the surging iron ore price. Bond yields generally fell on the back of soft data. While the oil price fell, the iron ore price continued to surge on the back of production cuts due to Vale's (BA:VALE) problems. And the Australian dollar fell below $US0.71 on the prospect of RBA rate cuts and as the US dollar rebounded.

• Our view on global and Australian share markets hasn’t changed. They have run hard and fast since their December lows and some sort of short term pull back is likely. There are plenty of potential triggers for a pull back including ongoing trade uncertainty, a risk of a resumption of the shutdown in the US and ongoing soft economic data globally – most notably in Europe over the last week. And in Australian shares look to have run too far too fast – economic growth looks to be slowing and while we expect the RBA to cut rates its probably still a way off.

• But as global policy swings to being more stimulatory and growth indicators improve shares should perform well for the year as a whole. Key to watch for will be further policy support globally and rate cuts in Australia, a decisive end to the US government shutdown dispute and signs the US debt ceiling will be raised relatively smoothly, a bottoming in profit revisions and good earnings reporting seasons globally and in Australia, stronger than expected economic data and a bottoming in PMIs and share markets breaking through resistance on strong breadth.

• RBA downgrades the outlook and moves to a neutral bias on interest rates. In the past week it acknowledged increased downside risks globally and in Australia and its Statement on Monetary Policy revised down its Australian growth and inflation forecasts. And consistent with this its dropped its mild tightening bias (the mantra that the next move in the cash rate is “more likely to be an increase than a decrease”) and replaced it with a neutral bias, ie the next move could be up or down. We think the RBA’s downwardly revised growth forecasts for 3% this year and 2.75% next year are still too optimistic and see it closer to 2.5% at most as the housing downturn depresses housing construction and consumer spending. This in turn will mean that inflation will stay even lower for longer than the RBA is forecasting.

• We continue to see the RBA cutting the cash rate this year and its now moving in this direction, but there is still a way to go yet. In the absence of a signficant negative shock this was never going to happen over night but would occur as part of a process starting with the RBA revising down its forecasts (done), moving to a neutral bias on rates (done), more downwards revisions to its forecasts, moving to an easing bias and then easing. It’s likely this will require several more months of soft data and the RBA is likely to prefer to see what sort of tax cuts/fiscal stimulus will flow from the upcoming April Budget and the outcome of the election. So they will likely prefer to wait till after the budget and election. Which is why we thought the first easing is likely to be around August, but it could come as early as June. Our view remains that the cash rate will be cut to 1% by year end in two moves of 0.25% each.

• While the Final Report from the banking Royal Commission does not point to a further tightening in lending standards it did put a stamp of approval on the APRA driven tightening by the banks that is continuing and there is nothing to suggest it will be reversed even though RBA Governor Lowe continues to express concern that it may have gone too far. There is still more to go in shifting away from using benchmarks to assess borrower spending and in terms of debt to income limits particularly with the start up of Comprehensive Credit Reporting this year. So with the housing downturn having further to go and the economy slowing the RC relief rally seen in bank share prices may have gone a bit too far too fast. One worry from the RC recommendations is in relation to mortgage brokers – they have played a huge roll in injecting competition into the mortgage market by making it possible for small lenders without a big shopfront presence to take mortgage business away from the big banks via the mortgage brokers. Moving to having borrowers pay for the services of mortgage brokers at a time when they are cash strapped is likely to significantly reduce competition in the mortgage market which would be bad for borrowers. So its understandable that the Government is not so sure about this recommendation.

• Gong Xi Fa Cai…Happy Lunar New Year for the Year of the Pig. Out of interest the average return in the US S&P 500 back to 1930 in years of the Pig is 18.1%, the best of all Chinese zodiac years. For Australian shares the average return in years of the Pig since 1930 has been 26.5% and its been positive in every one.

Major global economic events and implications

• US data was a bit light on. The non-manufacturing conditions ISM index for January slowed consistent with slowing growth but its still solid at 56.7. The trade deficit also fell with weaker imports. Meanwhile, the Fed’s latest bank lending officer survey showed some tightening in lending standards for corporate loans and less demand for both corporate and consumer loans. All of this is consistent with the Fed’s pause on rates.

• The US December quarter earnings reporting season has been stronger than expected but its not as good as previous quarters as the tax boost and underlying earnings growth has slowed. 325 S&P 500 companies have now reported with 72% beating on earnings with an average beat of 3.1% and 59% beating on sales. Earnings growth is running at 17.9% year on year for the quarter. As can be seen in the next chart the level of surprises and earnings growth is slowing down. US earnings growth is likely to be around 5% this year.

• Eurozone data continues to weaken with falls in German factory orders and German and Spanish industrial production and the European Commission revising down its growth forecasts. While the ECB may be dithering as to what to do next we remain of the view that another round of cheap bank financing (LTRO) is on the way soon.

• The Bank of England left monetary policy on hold as expected and also downgraded its growth forecasts with Brexit uncertainty weighing.

• Japanese wages growth slowed to 1.4% year on year in December and household spending growth improved but only to 0.1% year on year.

• China’s private sector Caixin services conditions PMI for January confirmed the impression from the official PMIs, which is that while manufacturing has slowed sharply the services sector is holding up well. This is important as the services sector is now far bigger than the manufacturing sector.

Australian economic events and implications

• Australia has just seen yet another week of soft data with a further sharp fall in home building approvals, very weak retail sales, a sharp fall in the services sector conditions PMI, a fall in job ads and the Melbourne Institute’s inflation gauge showing continuing weak inflation in January. Sure the December trade surplus was much better than expected but this was due to a slump in imports. Retail sales and trade look like making a zero contribution to December quarter GDP growth suggesting another quarter of weak GDP growth. The bottom line is that the housing construction cycle is turning down, the downturn in house prices looks to be weighing on retail sales, the labour market appears to be starting to slow and inflation remains MIA.

What to watch over the next week?

• In the US, its going to be back to politics to see whether Trump and the Democrats can resolve their squabble over the Wall and avoid a restart of the government shutdown from Friday – it appears that Congressional negotiators are making some progress on a compromise. Meanwhile US Treasury Secretary Mnuchin and Trade Representative Lighthizer will be in Beijing for another round of trade talks, with the March 1 deadline for the talks likely to be extended until President’s Trump and Xi next meet. On the data front expect core CPI inflation for January (Wednesday) to fall slightly to 2.1% year on year, December retail sales (Thursday) to show reasonable underlying growth and industrial production (Friday) to show a reasonable gain. It will also be another busy weak in the US earnings reporting season.

• Japanese December quarter GDP (Thursday) is expected to show a gain of 0.3% quarter on quarter or 0.1% year on year.

• Chinese January data is expected to show a further fall in exports and imports (Thursday), continued benign inflation (Friday) and credit data will be watched for a further pick up.

• In Australia, expect a further fall in housing finance (Tuesday). The NAB business survey (Tuesday) and the Westpac Melbourne Institute’s consumer confidence survey (Wednesday) are expected to remain softish.

• The flow of Australian December half earnings results will start to pick up with 44 major companies reporting including JB Hi-Fi (AX:JBH) and GPT (AX:GPT) (Monday), Transurban (AX:TCL) and Amcor (AX:AMC) (Tuesday), Cochlear (AX:COH) and CSL (AX:CSL) (Wednesday), South32 (AX:S32), Woodside Petroleum (AX:WPL) and AMP (AX:AMP) (Thursday) and Sonic Healthcare (AX:SHL) (Friday). 2018-19 consensus earnings growth expectations have fallen to around 4% for the market as a whole not helped by slower growth globally as well as locally with a large number of Australian companies warning of tough trading conditions, with resources profit growth running around 8% and the rest of the market around 2%. Resources, building materials, insurance and healthcare look to be the strongest with telcos, discretionary retail, media and transport the weakest and banks constrained. Key issues will be around the impact of the housing downturn, possible changes to franking credits and how the consumer is holding up.

Outlook for investment markets

• Shares are likely to see volatility remain high with the high risk of a short term pull back, but valuations are okay, and reasonable growth and profits should support decent gains through 2019 as a whole helped by more policy stimulus in China and Europe and the Fed pausing.
• Low yields are likely to see low returns from bonds, but they continue to provide an excellent portfolio diversifier.
• Unlisted commercial property and infrastructure are likely to see a slowing in returns over the year ahead. This is likely to be particularly the case for Australian retail property.
• National capital city house prices are expected to fall another 5-10% this year led again by 15% or so price falls in Sydney and Melbourne on the back of tight credit, rising supply, reduced foreign demand, price falls feeding on themselves and uncertainty around the impact of tax changes under a Labor Government.
• Cash and bank deposits are likely to provide poor returns as the RBA cuts the official cash rate to 1% by end 2019.
• The Australian dollar is likely to fall into the $US0.60s as the gap between the RBA’s cash rate and the US Fed Funds rate will likely push further into negative territory as the RBA moves to cut rates. Being short the Australian dollar remains a good hedge against things going wrong globally.