Risk On In Markets

Originally published by AMP Capital

Investment markets and key developments over the past week

• The past week saw “risk on” with the latest escalation in the US/China trade conflict being less than feared and reports that China is planning cuts to its import tariffs. This saw shares rally, bond yields rise, commodity prices gain, the US dollar fall and the Australian dollar rise. While the Australian share market participated in the global share market rebound, over the last week it has gone back to underperforming again reflecting its relatively defensive/high yield characteristics.

• The latest round of US/China tariffs announced over the last week had been long flagged and both the US increase (10% on $US200bn of imports from China, but not yet 25%) and China’s less than proportional retaliation (5-10% on $US60bn of imports) were less than feared. This and China’s commitment not to use a devaluation in the Renminbi as a weapon in the trade conflict along with reports that China is planning a broad cut to its tariffs leaves scope for negotiations. It’s also worth noting that we are still a long way from a full-blown trade war. After implementation of the latest round only about 12% of US imports will be subject to increased tariffs and the average tariff increase across all imports is just 1.6% implying about a 0.2% boost to inflation and a less than 0.2% impact on economic growth. In China the economic impact is likely to be less than 0.5% of GDP. This is all a long way from 1930 when the US levied a 20% tariff hike on all imports and other countries did the same making the depression “great”.

• The trouble is that further escalation is still on the cards as both sides are still well apart on the key issues (like IP protection) and Trump has threatened to increase tariffs on all imports from China. Chinese growth is far from collapsing and it’s using policy stimulus to offset the economic impact of the tariffs so is in no hurry to respond to pressure from Trump. Our view remains that a negotiated solution is likely but its unlikely to come until later this year or early next.

• Brexit is another issue that continues to wax and wane, albeit it’s not as globally significant as Trump’s trade conflicts. Lately the risks of a “no deal” Brexit, which risks throwing the UK into recession, has increased again with the “four freedoms” and the Irish border proving to be ongoing sticking points. It’s still too early to take a big British pound bet.

Major global economic events and implications

• US data remains strong. While manufacturing conditions softened in the New York region in September they strengthened in the Philadelphia region and both remain strong, the Conference Board’s leading indicator is continuing to rise and jobless claims fell further. Housing related data like starts, permits and sales doesn’t have a lot of momentum – beyond monthly volatility – but its still consistent with a flat/modest contribution to economic growth and at least its a long way from the pre GFC housing boom that went bust.

• As expected the Bank of Japan made no changes to monetary policy and continued to describe the economy as “expanding moderately”. Also, PM Abe was elected as LDP President adding to confidence that Abenomics will continue, but his victory was not overwhelming which may mean a humbler Abe. Core inflation rose to 0.4% year on year in August which is good but still a long way from the 2% inflation target.

Australian economic events and implications

• Australian data was light on over the last week but with the ABS confirming that home prices fell again in the June quarter, skilled vacancies rising slightly suggesting the labour market remains and population growth remaining strong in the March quarter. In terms of house prices our assessment remains that the combination of tighter bank lending standards, rising supply, poor affordability and falling capital growth expectations point to more falls ahead with Melbourne and Sydney likely to see top to bottom home price falls of around 15% out to 2020.

• But what about the risk of a property price crash as suggested by the recent Sixty Minutes report? Several things are worth noting in relation to this: predictions of a 30-50% property price crash have been wheeled out regularly in Australian media over the last decade including on Sixty Minutes; the anecdotes of mortgage stress and defaults don’t line up well with actual data showing low levels of arrears; borrowers have already been moving from interest only to principle and interest loans over the last few years without a lot of stress; and the 40-45% price fall call on the program was “if everything turns against us”. Our view remains that in the absence of much higher interest rates, much higher unemployment or a multi-year supply surge (none of which are expected) a property crash is unlikely. But the risks are now greater than when property crash calls started to be made a decade or so ago and so deeper price falls than the 15% top to bottom fall we expect for Sydney and Melbourne are a high risk. This is particularly so given the risk that post the Royal Commission bank lending standards become excessively tight and if negative gearing is restricted and the capital gains tax discount is halved after a change in government in Canberra. There is also a big risk that FOMO (fear of missing out) becomes FONGO (fear of not getting out) for some.

• One factor which supports the argument against a property price crash is ongoing strong population growth. Over the year to the March quarter it remained high at 1.6% which is at the top end of developed countries. As can be seen in the next chart net overseas migration has become an increasingly important driver of population growth in recent years.

• However, there are a few qualifications to this: there is some risk that the migrant intake may be cut; while accelerating population growth in Queensland will support Brisbane property prices, population growth is slowing in NSW and Victoria so its becoming a bit less supportive of property prices in those states; and the supply of new dwellings has been catching up to strong population growth so undersupply is giving way to oversupply in some areas. The risk of the latter is highlighted by the continuing very high residential crane count which is still dominated by Sydney and Melbourne, indicating that there is still of lot of supply to hit the market ahead. Out of interest Australia’s total residential crane count alone of 528 cranes is way above the total crane count (ie residential and non-residential) in the US of 300 and Canada of 123!

What to watch over the next week?

• In the US, news on the trade dispute with China will remain a focus. Beyond that the focus will be the Fed (Wednesday) which is expected to raise interest rates for the eighth time for this cycle taking the the Fed Funds range to 2-2.25% and signal that more gradual rate hikes are likely. Markets have already fully factored this in, so the interest will be on the Fed’s commentary about the outlook and its “dot plot” of future rate hikes. While the Fed may remove its description of policy as being “accommodative” its economic commentary is likely to be upbeat and the dot plot is likely to remain consistent with more gradual rate hikes ultimately taking the Fed Funds rate above the Fed’s currently assessed long run “neutral rate” of around 2.75-3%. This will likely mean more rate hikes over the next two years than the three and a half (including September’s) that the market is currently allowing for. On the data front in the US, expect ongoing home price gains and another strong consumer confidence reading (both Tuesday), slight gains in new home sales (Wednesday) and pending home sales (Thursday), ongoing strength in durable goods orders (also Thursday) continued strength in consumer spending but a fall back in core private consumption deflator inflation to 1.9% year on year for August (Friday).

• Eurozone inflation data for September to be released Friday is likely to show core inflation remaining around 1% year on year. Economic confidence data will be released Thursday.

• Japanese data to be released Friday is likely to show continued labour market strength and a rebound in industrial production.

• Chinese manufacturing conditions PMIs (Friday and Saturday) will be watched for the impact from the US trade conflict.

• In Australia, ABS data on skilled job vacancies (Thursday) are likely to show a bit of a slowing and credit growth (Friday) is likely to remain moderate. The interim report of the financial services Royal Commission will also be released with the risk it prompts a further tightening in bank lending.

Outlook for markets

• We continue to see the trend in shares remaining up as global growth remains solid helping drive good earnings growth and monetary policy remains easy. However, the risk of a correction over the next two months still remains significant given the threats around trade, emerging market contagion, ongoing Fed rate hikes, the Mueller inquiry in the US, the US mid-term elections and Italian budget negotiations. Property price weakness and approaching election uncertainty add to the risks around the Australian share market.

• Low yields are likely to drive low returns from bonds. Australian bonds are likely to outperform global bonds helped by the relatively dovish RBA.

• Unlisted commercial property and infrastructure are still likely to benefit from the search for yield, but it is waning.

• National capital city residential property prices are expected to slow further with Sydney and Melbourne property prices likely to fall another 10% or so, but Perth and Darwin property prices bottoming out, and Hobart, Adelaide, Canberra and Brisbane seeing moderate gains.

• Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.

• While the Australian dollar is working of very negative short positions and oversold conditions resulting in another short-term bounce, it’s still likely to fall to around $US0.70 and maybe into the high $US0.60s as the gap between the RBA’s cash rate and the US Fed Funds rate pushes further into negative territory as the US economy booms relative to Australia. Being short the Australian dollar remains a good hedge against things going wrong in the global economy.

All the best for a supreme weekend.