AMP Capital – 12 August 2016
Shares moved higher again over the last week with the US market hitting new record highs (albeit up just 0.1% for the week), eurozone shares rising 2.4% to their highest since May, Japanese shares up 4.1%, Chinese shares up 2.8% and Australian shares up 0.6%. Bond yields mostly fell, as investors remain unconvinced that the US Federal Reserve (Fed) is any closer to raising interest rates again. Commodity prices were mixed, with oil up, but metals down and a generally lower US$ saw the A$ briefly make it above $US0.77.
It’s now one year since China devalued its currency (by 3% August 11 2015) and broke the link to the US – and the sky hasn’t fallen! At the time there was much fear that this would drive massive capital outflow from China causing the Renminbi to plunge and destabilising the emerging world. Here we are one year later and while the Renminbi is now down 7% from its pre devaluation level, it has not crashed, there has been no avalanche of capital outflows from China, there has been little lasting impact on the emerging world and investors now seem more comfortable with a more flexible and volatile Chinese currency. So this has turned out to be another disaster that didn’t happen.
In a wide ranging speech, Reserve Bank of Australia (RBA) Governor Glenn Stevens provided a useful reminder of just how well the Australian economy has performed over the last decade – with no recession and relative stability despite the worst global slump since the 1930s and the collapse of the mining boom. While lots of factors have played a role in this good performance, the RBA under Glenn Stevens has played a huge role in this outcome. And I have no reason to believe that the contribution to the Australian economy from the RBA under Governor Steven’s successor, Philip Lowe, will be any less successful in the years ahead. Governor Stevens also provided useful insights on a range of other issues: that we are “kidding ourselves” if we think the debate about budgetary adjustment won’t have to become more “hard-nosed”; that there is only so much that monetary policy can do and that thinking about ways to maximise potential growth is not just for debate amongst “elites”; that Australia cannot but be affected by the whole developed world having ultra-low interest rates – with the obvious implication that we have to follow suite to some degree if we want the A$ to continue to help in the rebalancing of the economy; and that the inflation targeting framework is rightly flexible enough to allow for the current undershooting of the inflation target. The big takeout for me is that while it would be nice to get more help from other areas of economic policy, if inflation looks like remaining below target for an unacceptable period and if a strong A$ is contributing to this, then the RBA will likely cut rates again. We continue to allow for another rate cut in November.
Speaking of rates and the currency, the Reserve Bank of New Zealand (RBNZ) has exactly the same problem as the RBA: It has cut rates but because a cut was factored in, and maybe because it didn’t sound bearish enough, the NZ$ rose just as the A$ did a week earlier. The solution will be more cuts and more ‘dovishness’ from both the RBA and RBNZ.
What about the big Australian banks? The next chart shows the cash rate, the average one year bank term deposit rate and the standard variable mortgage since 1990.
Source: RBA, AMP Capital
Several things are worth noting. First the period of one-for-one moves in the standard variable rate and the cash rate over 1997 to 2007 was a bit of an oddity. Banks do not get the bulk of their funding overnight at the cash rate, but from a whole bunch of other sources. Movements in these were sort of consistent with the cash rate over the 1997-2007 period, so the cash rate was the key driver. Second, since the Global Financial Crisis (GFC), banks have been trying to get more of their funding from bank deposits, as it’s a more stable source of funding than, say, short term money markets. But it’s also more expensive. And to keep depositors on side, banks have had to pay them more. So for example the deposit rate line in the chart is now above the cash rate when prior to 2008 it was mostly below. Thirdly, banks have also been under pressure from regulators to raise more equity from their shareholders, and this is also more expensive (eg they have to pay a 6% or so dividend). All of which has pushed up the average cost of money the banks borrow relative to the cash rate – so mortgage rates have not come down fully with the cash rate. At the end of the day it is a highly competitive banking market, so those with a mortgage are free to call up their banks, threaten to refinance with someone else and ask for a better deal (who actually pays the standard variable rate of 5.2-5.3% now anyway?). Returning to the days where bank lending rates are regulated and banks resort to rationing the amount they lend based on ‘useful’ things, like who the customer knows at the bank, would not be a bright move. The danger is that all the bank bashing leads to a weaker banking system in which we all end up worse off. Finally, the argument that monetary policy is no longer effective because of banks partial and out of cycle rate moves is ridiculous. As can be seen in the chart, the main driver of bank mortgage rates through the cycle remains the RBA, via its cash rate.
Major global economic events and implications
US economic data was mixed, with a slight rise in small business optimism and continued strength in job openings and hiring but weak July retail sales, though this followed very strong and upwardly-revised June retail sales growth. Producer price inflation also fell in July. A big negative though was continued weakness in productivity growth, which is an obvious outworking of strong jobs growth and soft GDP growth. Putting aside issues about whether growth is being understated on the back of cheap or even “free” technologies that are significantly enhancing our lives, low productivity growth adds to concerns that potential growth is lower than currently thought, and flowing from this, that “normal” interest rate levels are also lower. However, I suspect GDP growth and productivity will move higher in the year ahead, as the detraction from US growth, flowing from a rundown in inventories and energy investment, has likely run its course. In terms of the Fed, the soft July retail sales data make a September rate hike even less likely (market probabilities are currently just 16%), but our base case remains for a December hike.
The US June quarter reporting season is now more than 90% done, and indicates a clear rebound in earnings from their March quarter low. 78% of companies have beat on earnings and 56% have beat on sales, both of which are above normal levels. More importantly, while earnings are down 2.5% year on year (yoy), they have come in around 3% better than expected and are up about 9.5% on the March quarter low.
Japanese data was a bit better, with solid gains in machine orders and economic sentiment.
Chinese economic data for July was weaker than expected with a slight slowing in industrial production (from 6.2%yoy to 6%), retail sales and fixed asset investment, continued weakness in exports and imports, and weak credit and money supply growth. It’s early days yet, and recent floods may be impacting, but so far the data suggests that Chinese growth in the current quarter may be edging down to around 6.5-6.6% yoy. Expect continued policy easing in China, including more interest rate cuts. Meanwhile, although a fall in food price inflation saw CPI inflation fall slightly, producer price deflation is continuing to fade which is good news for nominal GDP growth in China.
Australian economic events and implications
Australian data was a mixed bag, with business conditions and confidence down slightly in July but remaining relatively resilient (despite the political uncertainty at the time), consumer confidence up slightly in August to be around its long term average (helped by the latest rate cut) and housing finance up solidly again in June. The okay level of consumer and business confidence point to moderate but not spectacular growth in the economy and the rise in housing finance tells us that overall the housing sector is still solid. In terms of the latter, it looks like investor lending is having a bit of a bounce after growth in the total bank book of lending to investors fell way below the Australian Prudential Regulation Authority (APRA) 10% limit, but it’s doubtful that investor lending will be allowed to pick up too far, as there is a good chance that APRA will lower the 10% limit to around 7-8%.
The Australian June-half earnings reporting season has kicked off on a relatively ordinary note, with so far only 37% of companies exceeding expectations (compared to a norm of 45%). However, 71% have seen their earnings rise on a year ago, 52% have seen their share price outperform the market the day results were released and 93% have either maintained or increased their dividends. It’s also still early days with less than 20% of results out so far.
Source: AMP Capital
Source: AMP Capital
What to watch over the next week?
In the US, expect the minutes from the July Fed meeting (Wednesday) to confirm that at the time it remained dovish and cautious, but bear in mind that since then we have seen another strong US jobs report and a further strengthening in financial markets. Meanwhile, expect the August home builders conditions index (Monday) to strengthen slightly to a solid index reading of 60, housing starts to fall slightly after a very strong rise in June – but permits to rise further, headline CPI inflation to fall slightly to 0.9% yoy, but core inflation to remain unchanged at 2.3% yoy and industrial production to rise modestly (all due Tuesday).
In Europe, the minutes from the European Central Bank’s (ECB) last meeting (Thursday) are likely to confirm it remains dovish, but in ‘wait and see’ mode.
Japanese June quarter GDP growth (Monday) is likely to show growth slowing to just 0.2% quarter on quarter, after 0.5% qoq in the March quarter.
In Australia, expect June quarter wages data (Wednesday) to show wages growth at a new record low of 2% year on year, reinforcing the downwards pressure on inflation. Employment data for July (Thursday) is expected to show flat employment after a high employment sample rotates out and given that recent forward looking job indicators have been more mixed lately. Unemployment is likely to rise slightly to 5.9%. Meanwhile, the minutes from the last RBA board meeting (Tuesday) are likely to confirm the dovish tone evident in the August Statement on Monetary Policy.
The June quarter earnings reporting season will ramp up in Australia as we move into the two busiest weeks for reports, with 66 major companies due to report in the week ahead, including JB HiFi, BHP, Wesfarmers, CSL, QBE, Origin, AMP, IAG, DUET, Lend Lease and Woodside Petroleum. After the downgrades since the last reporting season back in February, the hurdle to avoid disappointment is now relatively low. Consensus expectations for 2015-16 earnings are for an 8% decline in profits driven by a 50% fall in resources earnings and a 2% fall in bank profits, leaving profits in the rest of the market up just 1%. Key themes are likely to be: improved conditions for resources companies following a stabilisation in commodity prices; constrained revenue growth for industrials; ongoing cost cutting; continuing headwinds for the banks; and an ongoing focus on dividends. Sectors likely to see good profit growth are discretionary retail, industrials, gaming and healthcare. Expect disappointers to be punished severely.
Outlook for markets
After a period of strong gains shares are due to take a breather, and weak seasonal data for August and September along with risks around Italian banks, the Fed and global growth generally could be the drivers. However, after a 1-2 month correction or consolidation, we anticipate shares to trend higher over the next 12 months helped by okay valuations, very easy global monetary conditions and continuing moderate global economic growth.
Ultra-low bond yields point to a soft medium term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity, low inflation and ongoing shocks. That said, the recent bond rally has taken yields to pathetic levels leaving them at risk of a snapback.
Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors.
Dwelling price gains are expected to slow to around 3% over the year ahead, as the heat comes out of Sydney and Melbourne thanks to poor affordability, tougher lending standards and as apartment prices get hit by oversupply.
Cash and bank deposits offer poor returns.
With the Fed continuing to delay rate hikes and the A$ pushing up to around $US0.77, a break of April’s high of $US0.78 and a push up to $US0.80 is now looking likely. Beyond the short term though, we see the longer term downtrend in the A$ ultimately resuming as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed eventually resumes hiking, the risk of a sovereign ratings downgrades continues to increase, commodity prices remain in a secular downswing and the A$ sees its usual undershoot of fair value.