Very High Confidence Readings Globally

Originally published by AMP Capital

Investment markets and key developments over the past week

• Share markets rose over the past week helped by Congress passing US tax reform, ongoing strong economic data globally and some relaxation of the policy focus on “deleveraging” in China. Bond yields generally rose led by the US bond market which started to factor tax cuts in. Commodity prices also rose but the US dollar fell and this saw the Australian dollar push back to around $US0.70.

• We are continuing to see record or near record highs in various business and consumer confidence readings globally. Historically it doesn’t get much better than this and we saw how similar readings around 1999-2000 and 2007 ended badly. The big difference this time compared to those periods of similar highs in confidence readings is that at those peaks inflation was an issue and global monetary policy was tight and bearing down on growth, whereas now inflation is still low and monetary policy remains easy. In other words, we are still in the “sweet spot.”

• US tax reform passed by Congress, markets still underestimating the boost to US growth. Tax reform will pump around 1% into the US economy via lower household and corporate taxes – a significant part of which will be spent particularly with many households likely to be surprised by the size of the tax cut they get and instant write offs spurring business investment. And lower corporate taxes are estimated to boost earnings by 10-15%. With the US economy far tighter than it’s been at the time of all past major tax cuts since President Kennedy (unemployment is now 4.1% compared to an average 7% at the time of past tax cuts) the likelihood of a boost to wages growth and inflation is high. So US shares are likely to have more upside as the boost to growth and profits are factored in, the Fed is likely to hike four times next year and with the US futures market factoring in less than two Fed hikes this is likely to translate into a further rise in US bond yields and a more upside in the US dollar. This should flow through to global and Australian bond yields and at the same time put downwards pressure on the Australian dollar against the US dollar. All of this this is only likely to become apparent over time as the impact of tax reform shows up in hard data.

• Another partial government shutdown averted in the US, and no shutdown likely in January either. Congress with the help of Democrats has passed a bill to keep Fed government funding going to January 19 and waive pay-as-you-go automatic spending cuts that the tax reform plan would have triggered. So no shutdown from December 23 and President Trump can now sign tax cuts into law. Congress is not yet ready to finalise a full year spending bill (given unresolved issues around “dreamers”, additional disaster relief, defence spending), hence another short-term measure. Congressional Republicans and Democrats are well aware after the 2013 experience of the blame they will take if a shutdown happens.

• US trade tensions with China expected to rise in 2018. One of the biggest surprises for many in 2017 was that we got President Trump the business friendly pragmatist as opposed to Trump the rabble rousing populist. The risk is that this may change a bit in 2018. Tax reform is already bedded down but with political pressure around President Trump likely to escalate as the Mueller investigation closes in and the prospect of the GOP losing control of the House in the mid-term elections the risk that he resorts to populist measures to boost his base will rise. With the release of his “America First” National Security Strategy – which saw China deemed a rival trying to erode US prosperity and security – it’s likely that trade sanctions targeted at China will loom large on this front. Trump is likely to avoid an all out trade war with China as he needs its help on North Korea and knows that higher prices on Chinese consumer goods will not go well in an election year and China is likely try and calm things down – but the announcement of various measures by the US and fears of a trade war may cause bouts of market volatility as 2018 progresses.

• The Catalan election in Spain saw the independence parties retain their regional parliamentary majority (with 70 out of 135 seats) but the experience of the last few months, the lack of agreement amongst the separatists on how to proceed and the lack of a clear popular mandate indicate another unilateral declaration of independence is unlikely. The implications for Europe and the Euro are minimal regardless.

• The Chinese Government’s Central Economic Work Conference confirmed a focus on high quality growth and specifically financial risk containment, poverty reduction and environmental protection. Interestingly the emphasis on “deleveraging” appears to have been reduced which is probably appropriate given that the real issue around debt growth in China is its high savings rate and reliance on bank lending. Overall our assessment remains that China is on track for growth around 6.5% in 2018 but as in recent years is less focussed on the precise number. This in turn should be supportive of commodity prices.

Major global economic events and implications

• US data remains strong, with continuing ultra low jobless claims, strong readings for regional manufacturing conditions surveys, robust growth in the Conference Board’s leading index and strong readings for home builder conditions, housing starts, home sales and house prices.

• German IFO & French INSEE business confidence readings remained ultra strong in December as did Eurozone consumer confidence pointing to a further pick up in growth.

• As expected the Bank of Japan made no changes to monetary policy and with inflation way below target will continue with QE and its zero 10-year bond yield target for at least the next year.

Australian economic events and implications

• In Australia, the Federal Government’s Mid Year Economic and Fiscal Outlook provided a welcome improvement to the budget outlook – it was only minor but at least it’s going in the right direction and keeps the AAA rating secure. The Government’s growth assumptions look reasonable, but a key risk is that their wages assumptions are still look optimistic. The small improvement in the budget outlook helps the Government in its desire to announce tax cuts ahead of the next election, but to be of any significance they would require offsetting savings elsewhere to maintain the return to surplus.

• While the minutes from the last RBA meeting showed more confidence in growth and the labour market, the RBA noted that the combination of strength in activity and low inflation “could continue for a while yet.” The next move by the RBA on rates will be up but not until end 2018 at the earliest.

• Where are the jobs coming from? Over the last year the big job gains have come in healthcare and construction.

What to watch over the next two weeks?

• In the US, the main focus in the next two weeks will be the jobs data (due January 5) which is expected to show a 190,000 gain in payrolls and a further fall in unemployment to 4% but wages growth remaining subdued at 2.5% year on year. In other data, expect further gains in home prices (December 26), continued strength in consumer confidence and a rising trend in pending home sales (December 27) and continued strength in the ISM manufacturing conditions index (January 3) and the ISM non-manufacturing index (January 5). The minutes from the Fed’s last meeting (January 3) are likely to reiterate that its on track for further gradual interest rate increases.

• Eurozone core consumer price inflation for December (January 5) to show a small rise but only back to 1% year on year.

• Japanese data for November (December 26) is expected to show continued labour market strength and an improvement in household spending but with core inflation remaining around 0.3% year on year. Growth in industrial production (December 28) is likely to have remained strong.

• Chinese official business conditions PMIs (December 31 and January 2) will be watched for any signs of post Party Congress slowing, but it’s likely to be minor.

• In Australia, private credit data (December 29) is expected to show continued moderate growth, AIG and CBA business conditions PMIs (January 2 and 4) are likely to remain solid and the November trade surplus (January 5) is likely to show a bounce back helped by a rebound in iron ore prices. Perhaps most interest will be in CoreLogic data (January 2) which is expected to show another month of roughly flat capital city home prices as Sydney prices continue to soften.

Outlook for markets

• Shares are likely to see their traditional Santa Clause rally over the Christmas/New Year period. For 2018, continuing strong economic and earnings growth and still easy monetary policy should keep overall investment returns favourable but stirring US inflation, the drip feed of Fed rate hikes and a possible increase in political risk are likely to constrain returns and increase volatility after the relative calm of 2017:

• Apart from the likelihood of a correction early in 2018 and more volatility through the year, global shares are likely to trend higher through 2018 and we favour Europe (which remains very cheap) and Japan over the US, which is likely to be constrained by tighter monetary policy and a rising US dollar. Favour global banks and industrials over tech stocks that have had a huge run.

• Emerging markets are likely to underperform if the $US rises as we expect.

• Australian shares are likely to do okay but with returns constrained to around 8% with moderate earnings growth. Expect the ASX 200 to reach 6300 by end 2018.

• Commodity prices are likely to push higher in response to strong global growth.

• Low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds.

• Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors.

• National capital city residential property price gains are expected to slow to around zero as the air comes out of the Sydney and Melbourne property boom and prices fall by around 5%, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms.

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

• After a short term bounce higher, the Australian dollar is likely to fall to around $US0.70, but with little change against the yen and the euro, as the gap between the Fed Funds rate and the RBA’s cash rate goes negative. Solid commodity prices will provide a floor for the Australian dollar though.

The weekly will return for the week ending January 5.