Throughout the Month of March the global economy continued to grow. Economic data released during the month had a slightly softer tone compared with previous months but continues to signal robust economic growth. The Us Federal Reserve (Fed) raised rates as expected and the Reserve Bank of Australia kept rates on hold as expected. Optimism for US economic growth prospects have been dampened by President Trump’s announcement of tariffs on goods from China. China has offcourse retaliated. Thesituation could escalate to a trade war of which the consequences could extend to weaker global growth and higher inflation. While Australia seems to have been spared so far, it will inevitably suffer from weaker global growth if a trade war were to begin.
We have seen long-term bond yields rise over recent months, although still at very low levels. We have also seen equity market volatility spike from very low levels. The RBA took a swipe at Trump saying that recentvolatility was ?partly because of concerns about the direction of international trade policy in the United States?. Creditspreads have also widened in the wake of the volatility, and we note the following from our recent FlashNote ?The Chase for Yield?.
Here we have the Australian 5-year iTraxx (Source: Bloomberg). It is generally regarded as a proxy for domestic credit spreads. As you can see, during March, credit spreads have widened. During 2016 and 2017 equity markets were experiencing a prolonged period of low volatility and complacency was creeping in. Just take US equity market valuations now topping 19xPE compared to the long run average of 15xPE. This low volatility environment led to a tightening of credit spreads. This seems to have reversed and will impact longer dated interest bearing securities the most.
Financial conditions remain expansionary and continue to support our view to being overweight risk assets.
In the US economic readings continued to show mixed results but still support a strengthening economy. Unemployment has remained stable at 4.1% allowing wages growth to settle back a touch and relieving pressure on inflation. February new housing starts and permits were down 7% and 5.7% respectively and new home sales were down 0.6% month on month for February. Other leading indicators remained strongincluding the purchasing manager’s index and other consumer sentiment readings. While the data is mixed, economic growth is still strong and further interest rate increases are likely. The growth should be sustained so long as the tit-for-tat with China does not escalate into a trade war.
A US / China trade war could derail the strong international trade growth for China. Australia will largely be spared and could even benefit in some ways but will eventually be caught up in any global downdraft. For the time being China continues to report solid GDP of at least 6.5% year on year and solid prospects for retail and fixed asset spending.
In Europe, where there remains plenty of slack to support low interest rates and growth, also showed some slightly weaker numbers this month, all-be-it still very good numbers particularly for the manufacturing sector. Retail sales and industrial production fell slightly. European policy makers are still of the view that there will be no more interest rate cuts and have moved to a neutral position. The new Italian government may prove to be a headache with a reluctance for further economic reform and fears of US tariffs.
In Australia the RBA noted:
?There has… been some tightening of conditions in US dollar short-term money markets, with US dollar short- term interest rates increasing for reasons other than the increase in the federal funds rate. This has flowed through to higher short-term interest rates in a few other countries, including Australia.?
They also referenced falling prices of Australian commodity exports. They largely looked through the marginally weaker GDP and employment prints from last month and referenced more positive forward looking expectations. Like last month, they continued to highlight improving business conditions, increasing non-mining business investment and higher levels of public infrastructure investment, but also continued to emphasise households as a potential source of risk.
Household debt has continued to rise. This has led to a continued trend of dipping into our savings. Wages have risen marginally but not enough to support any real change in our spending habits. Employers have noted that it is becoming more difficult to find the right employees and may have to start to pay up, the issue is not broad based. The unemployment rate however ticked up a little indicating wage growth and employment still have some way to go.
From the RBA’s perspective the low level of interest rates continues to support the Australian economy. They are awaiting further reductions in unemployment to drive more competition for employees and thus to drive up wages and inflation. This is likely to take some time and there is the risk a US / China trade war that could derail this slow but positive direction of the Australian economy. While we have been of the view that there will be a rate increase this year, this position has weakened this month.