Royston Capital Economic Update
August edition 2018, By Chris Boag
During the month of July, we saw most major share markets rise. The backdrop was one where there were strong company earnings reported, especially in the US, an easing of trade tensions, tempered by a slightly slowing rate of GDP growth. World GDP growth continues to be above trend, underpinned by an accelerating US economy. China’s growth has moderated, and European growth may also moderate. Australian GDP growth has accelerated and looks in good shape to continue the trend. As we discussed last month the increasing concerns of trade wars present a real and immediate threat to risk assets (equities). The ‘policy puts’ we have often relied on have however been marked down to a lower strike price meaning any correction could be deeper than expected.
In the US, the economy continues to expand and jump ahead of its peers. It’s the only major economy where leading indicators are still rising. There are some indications that US real GDP could top 4% in the second quarter, more than double most estimates of trend growth. This cannot be sustained. The unemployment rate stands at a multi-decade low of 3.75% with very little slack. This is great news, however, mainstream economic theory states that governments should tighten fiscal policy at this stage to temper the economy and build a war chest for the inevitable downturn. Trump is not an economist so of course he is adding fuel to economic fire with his tax cuts and big increases in Government spending. The economic outcomes are predictable; the labour market will overheat, and wages will accelerate. Workers will naturally spend their bounty increasing aggregate demand, probably beyond the economy’s productive capacity, inflation will rise. There are already signs of this scenario starting to play out.
The US Federal Reserve has an ideal inflation target of 2.2-2.3%. An increase above this would not necessarily worry the Fed however a sustained move above 2.5% would likely see a more aggressive policy response. The unemployment rate has now fallen 0.7% points below the Fed’s estimate of full employment which is great, but, history tells us that there has never been a case in post war era where the unemployment rate has risen by more than 1/3rd of a percentage point without a corresponding recession. The Fed will want to avoid a situation where the unemployment rate has fallen so far that it has nowhere to go but up. We note that Fed Chairperson J Powell has moved to hold press conferences every 6 weeks opening the door for more frequent rate hikes.
Here’s the rub, the US housing market is in great shape, and sensitive to interest rates but other sectors of the economy are not. It will take a pronounced increase in rates to generate enough distress in the corporate sector exacerbated by the low base from which we are starting. This will lead to a stronger US$ and will cool the economy by diverting some spending to imports. We think that the trajectory of interest rates is up and that the pace of rate hikes is at risk of accelerating.
During the mid-nineties I produced an economic paper on the Asian Currency Crisis. I won’t go into details except to say that there are some similarities with what is happening today. A large proportion of emerging market debt is in US$ (some say up to 80%). A vicious cycle could erupt where a stronger dollar makes it difficult for borrows to pay back their loans, lending to capital outflows from emerging markets and an even stronger US$. Emerging markets could raise interest rates to help prevent their currencies from plunging, however, this will make it difficult for local currency borrows to pay back their loans…….tricky position to be in.
Back in 2015 when emerging markets succumbed to pressure, China saved the day with a massive new stimulus. The Governments’ actions boosted all demand for industrial commodities. As we have noted in recent economic updates, the Chinese economy is slowing. So far, the policy response has been muted. I would have no doubt that China will stimulate their economy if the slow down looks like a hard landing. However, the bar for such stimulus is higher today than it was in 2015 due to elevated debt levels, excess capacity, pollution etc.
If you have been wondering why Xi Jinping has been quiet lately it’s because China’s politburo (the principal policy making committee of a communist party) and other senior leaders (most importantly the retired members of previous politburo) is having their annual summer camp in Beidaihe right now. This annual meeting could change courses of history – from leaders (including Mao himself twice) getting kick out of the government to smaller but significant changes to economic or social policies. Given the trade war is the most significant topic this year, it will be crucial to observe the immediate news-flow over the next 14 today to see if the meeting convinced Xi Jinping to change his stance.
In Europe, GDP growth is slowing but remains above long term trend. It now looks like the Euro area peaked last year. The weakening trend seems at least partly a function of slower growth in China and emerging markets. There is no immediate reason to believe growth will re-accelerate especially with Italy’s woes set to continue for some time. It is possible that the ECB could yet again extend the final deadline for the windup of the QE program.
In Australia GDP growth remains robust supporting the RBA’s view that GDP will average a touch above 3% for 2018 and 2019. We are also seeing stronger employment growth and further falls in the unemployment rate support by a peaking participation rate. Housing activity remains soft and there are continued concerns about high household debt in the absence of weak ages growth. We don’t see this scenario lasting for too much longer and expect inflation also to pick up. Inflation will be fuelled by rising international producer prices combined with a lower AUD$ to push up prices. A tighter labour market will eventually lead to an acceleration in wages growth. Food prices are likely to be impacted by the drought in QLD and NSW.
Our view is the RBA will have to tighten interest rates. Interestingly, economist Stephen Roberts is an outlier believing it could be as early as November this year. CBA are suggesting early 2019 and Westpac are suggesting sometime in 2020. I don’t care for these longer-term predictions, I think it’s better to say, ‘rates on hold for the foreseeable future’. Our view is that rates will go up, but we need to see more multiple economic readings (particularly wages growth) that justify a rate rise before the we think the RBA will make its move.
The current interest rate environment remains supportive of risk assets although clouds are gathering. Those accustomed to thinking that there is a ‘Fed Put’ waiting in the wings will be disappointed. The Fed wants slower growth and it may require weaker asset prices to achieve it. The ‘Fed Put’ is still there it’s just the strike price has moved lower. Likewise, growing financial and economic imbalances will limit the desire for China to further stimulate its economy so the ‘China stimulus put’ has also shifted lower. The same goes for the ‘ECB Put’. The ECB is hoping to wind down its asset purchase program (QE), meaning a key buyer of Italian debt is stepping back right when it is needed the most. The loss of these three policy-puts, along with rising trade protectionism, means the outlook for global outlook for risk assets is becoming more challenging.
This information was prepared by Royston Capital, ABN 98 158 028 392 AFSL 438262. The information in this presentation is current as at 6 July 2018 unless otherwise stated.
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Sources: Admiral Investments, Alexander Funds Management (Steven Roberts); RBA, BCA Research.