The ‘Trump Trade’, which saw equities rise strongly, bonds sell off, and the US dollar strengthen, has weakened as investors reassess the Trump administrations ability to implement its economic agenda. The ‘Macron Trade’ is however, on. His ascendancy to the 2nd round run-off against Le-Penn for the French Presidency has eclipsed that of Trump. Meanwhile global economic growth has continued to show signs of improvement with international agencies shifting global growth forecasts higher. US economic growth indicators have settled back a little, although most survey reports of consumer and business activity remain strong. Surprisingly growth in China firmed and less surprising has been the improvement in Europe. Central banks continue to edge away from their extreme expansionary settings and the US Federal Reserve has even talked about running down its bloated balance sheet in tandem with slowly rising interest rates. The Reserve Bank of Australia has been on hold for an extended period as it balances competing risks to the economy but recent comments imply a slight shift to indicate the next move will be up. Aside from elections in Europe and central bank policy, geopolitical risks continue to simmer. The Trump administration is taking a tougher stance against Iran, Syria and notably North Korea.
In the US the latest PMI showed that the economy lost further momentum although there were indicators it could pick up later in the year. Over the years the winter quarters have usually shown a dip in growth before improvement later in the year. The slowdown is most likely to have been due to worse than usual winter particularly in March and we expect that most economic indicators will show improvement in April.
While inflation pressure slipped back in March, various comments from senior Fed officials implied they were on track to deliver another two rate hikes in 2017. The recent Fed meeting minutes revealed discussion about the end of reinvestment of the proceeds from maturing assets in the Feds portfolio, implying monetary policy tightening could become a combination of a rising funds rate and reduction in the balance sheet. The next meeting of the Fed is in June when a 25bpt hike to 1.0% is likely. The Fed is also watching the magnitude of Trumps tax cutting which may have a bearing on the reflation trade in financial markets and in turn whether another general push upwards in global interest rates is on the cards.
In China, economic data relating to March and 1st quarter have surprised on the upside. This implies the Authorities are managing to sustain growth above 6.5% while also conducting reforms to temper excessive residential real estate development and house price speculation; improving bank lending practices; and running down the most polluting state-owned enterprises. Interestingly, the improvement occurred despite the beginnings of a sharp fall in the iron ore price (not consistent with accelerating industrial production in China) and small monetary policy tightening.
Last month, Zouping in China’s Shandong province made international news when one company’s bankruptcy has led to concerns about its guarantors. In the last several years, privately-owned small and medium companies have had troubles accessing bank credits, and groups of companies have decided to guarantee one another’s balance sheet to reach a critical mass necessary to access the banks. When one company goes bankrupt, its fellow guarantors will need to shoulder the now bad debt. This can, in theory, lead to multiple bankruptcies if the guarantors then go bankrupt and force the issue to their own guarantors. We do not believe that this will happen, but this episode highlights that solving its debt issue is a major priority for the Chinese government.
There are early signs that the Euro Zone will reduce stimulus later this year as most economic indicators continue to improve. The improvement in European economic activity is increasingly being recognised by the European Central Bank, although it remains acutely aware of potential downside risks. A larger area of focus is the uncertainty surrounding the stability of the European Political union. The first round French presidential election appears to be presenting non-mainstream party candidates for the second round; one very pro-EU and the other determined to provide a fatal blow to the EU.
The Australian economy is continuing to grow modestly. The minutes of the RBA meeting highlighted erratic employment growth, sticky unemployment rate, a housing market that warrants close attention and vulnerability to key growth facilitators. Specifically weakness in demand from our biggest trading partner, China, or a deduction in spending by Australian households caused by a fear of a housing downturn, will impact economic growth. Australian export demand looks robust however, the weather events in Western Australia and Queensland have damaged transport infrastructure, limiting supply. Temporarily, net exports could soften, although are likely to pick up later in the year. We also not Federal Government infrastructure spending is likely to rise with a focus on airports and rail.
In this evolving economic environment the RBA is increasingly caught between opposing forces; weak wages growth and with high levels of household debt squeezing consumer spending. Improving global growth and the remnants of strong Australian housing activity point to a need to raise rates while a weak labour market, weak wages growth, low inflation and over-indebted household sector need accommodating monetary policy. The RBA is likely to leave rates on hold for now while growth in the US and Europe accelerates and China continues to tentatively rebalance.
Royston Capital is a privately owned and operated business. (AFSL: 438262 ABN: 98 158 028 392)
This information is of a general nature only and has been provided without taking account of your objectives, financial situation or needs. Because of this, you should consider whether the information is appropriate in light of your particular objectives, financial situation and needs. No representation is given, warranty made or responsibility taken about the accuracy, timeliness or completeness of information sourced from third parties. Because of this, we recommend you consider, with or without the assistance of a financial adviser, whether the information is appropriate in ligh t of your particular needs and circumstances.
Sources: Alexander Funds Management, Admiral Investments, Morningstar, Reserve Bank of Australia, CommSec.
Past performance is not a reliable indicator of future performance. Projected earnings are not guaranteed.
After the volatility and market turmoil caused by British referendum to leave the European Union (Brexit), markets rallied strongly in July based on the belief that further monetary easing, or at least a reduced tightening bias, was in the offing as central banks around the world assessed the likely impact of Brexit and weaker growth on their economies.
In Australia markets rallied strongly, up 6.3% for the month, as a Liberal party victory in the national elections combined with weaker than expected inflation numbers – with the Q2 inflation number of 0.4% resulting in the lowest annual reading in 17 years of 1.0% – supporting the expectation of further rate cuts. These came in the August Reserve Bank of Australia (RBA) meeting with a further cut to 1.5% which is a record low for the country. Given markets had largely anticipated this, the currency did not fall as a result, and markets are already pricing in a further rate cut later this year.
In Japan, an upper house election which strengthened the incumbent Abe government combined with a ¥13.5 trillion (?A$170bn) stimulus package have seen that market rally strongly in July, up 6.4%. This followed a poor June which was impacted by the Bank of Japan indicating it was reluctant to provide further stimulus.
In Europe, Gross Domestic Product (GDP) growth weakened slightly in Q2 up 1.6% year-on-year vs 1.7% year-on- year in Q1. Concern about Britain’s Brexit vote has faded somewhat although the UK has yet to start the formal withdrawal process. Both the European Central Bank and the Bank of England (BoE), did nothing at their respective July policy meetings, the BoE cut rates in its August meeting to a record low 0.25%. It also announced a bond buying programme for both government and corporate bonds and a schemed to encourage banks to lend to business.
The expectation of continued policy easing also saw European share markets to rally in July, but the EU remains at risk of further members leaving and indeed complete disintegration medium term. Other EU members will be keeping a close eye on the UK exit process, and the EU itself is therefore incentivised to be as tough on the UK as possible to dissuade further defections.
China growth continues to disappoint, with Q2 GDP coming in at 6.7% despite significant government stimulus over the past 12-18 moths as funds have been directed to underperforming state owned enterprises, limiting the efficiency of transmission to the broader economy.
In the US the Federal Reserve (the Fed) left rates on hold in July but the Fed has left the door open for a September rate rise amid conflicting signals. US Q2 GDP growth of 1.2% fell well short of the 2.6% expectations, however employment numbers surprised on the upside, with the non-farm payrolls report for July showing the US economy added 255,000 jobs in the month, beating economists’ expectations for growth of 180,000. Net-net however, the soft GDP growth profile in particular makes it unlikely, in our view, that the Federal Reserve will be able to hike rates at its next meeting in September.
Overall, while we see some green shoots of a recovery, we continue to believe that that recovery is fragile and overestimated given the relatively high earning expectations built into prices. As a consequence we continue see risks as to the downside in equity markets this reporting season as markets adjust their earnings outlook. Specifically, we continue to remain underweight the financial sector as we remain cautious on banks given the continuing risk around net interest margins for the banks while remaining overweight in the defensive healthcare sector, and the consumer discretionary sector. While the latter is not normally viewed as defensive, we have chosen companies with more significant barriers to entry or, in the case of REA, exposure to the real estate sector which is likely to remain buoyant on the back of continued low interest rates.