24 March 2017
The US share market finally saw a daily decline greater than 1% for the first time since last October and this dragged other share markets down to greater or lesser degrees over the last week. Chinese shares rose 1.3% over the week, but US shares fell 1.4%, Eurozone shares fell 0.2%, Japanese shares lost 1.4% and Australian shares fell 0.8%. Worries about whether President Trump will be able to pass his pro-business agenda of tax cuts, deregulation and infrastructure spending were the main drivers, but high levels of short term investor optimism have left the market vulnerable. The risk off tone in markets saw government bond yields decline, credit spreads widen and commodities excepting gold weaken. The US$ also fell, but this didn’t stop a decline in the A$.
Will Trump’s pro-business agenda pass Congress after the vote on a replacement for the Affordable Care Act (or Obamacare) was pulled? Can the Republicans get their act together? A common concern seems to be that if Trump and the Republicans can’t pass their Affordable Care Act (or Obamacare) replacement, what hope have they got for the bigger measures around tax cuts, etc? This reasoning is too simplistic. Obamacare had three key elements: Federal spending on healthcare subsidies; tax hikes to pay for them; and regulations imposed on health insurers. The Republican House leadership reasoned that if they reverse the spending increase and tax hikes then their Obamacare reform could pass through the Senate as part of the budget reconciliation process, which just requires 51 votes (out of 100 Senators) which they have, rather than the normal 60 votes (which they don’t have) if they push for removal of regulations as well. The sticking point was that the Freedom Caucus (a group of conservative tea party sympathetic Republicans in the House) wanted to remove the regulations too which would mean that any bill that passes in the House probably wouldn’t pass in the Senate. So the decision was taken that it’s all too hard and so the vote was pulled. This is good because it was just a distraction. But a failure of the Obamacare reform does not mean that Trump’s pro-business reforms will be stalled. The Freedom Caucus, the broader Republican Party in Congress and Trump all want lower taxes and less regulation and would prioritise this as they want to “starve the beast” of government as they see it. The Republican Party (‘GOP’) also realise that given the risks around Trump’s presidency (investigations around links to Russia, risk of eventual impeachment) and the risk they lose the Senate in next year’s mid-terms, mean that they only have a small window to get through the reforms they want. So they are not going to let the failure (so far) to repeal Obamacare get in the way of their small government agenda. The bottom line is that Trump’s pro-business agenda remains on track. Out of interest, note that on Friday Trump formally approved the Keystone XL pipeline, his third energy infrastructure project to be approved.
The tragic events in London perpetrated by another deranged nutcase provide another reminder of the ongoing terrorist threat. But as has been the case with recent terrorist attacks the impact on investment markets was minor, as investors have become accustomed to them (much as occurred a generation or so ago with the IRA and other terror attacks in Europe) and their economic impact remains insignificant.
In Australia, signs continue to point to an imminent fresh round of macro prudential controls to slow lending to property investors and further tighten home lending standards. The minutes from the Reserve Banks of Australia’s (RBA) last Board meeting clearly indicate that it has become more concerned about a “build-up of risks associated with the housing market” and there is reportedly a special regulatory working group – composed of the RBA, APRA and ASIC – looking at the issue. Likely measures include a cut in the cap on annual growth in the stock of investor lending to 5-7% from 10% now (it’s been running at 8.5% lately) and tougher interest rate tests for borrowers. In fact, with out of cycle bank mortgage rate hikes heavily skewed to property investors (at around +25 basis points) as opposed to owner occupiers (at around +3 basis points) it’s clear that the regulators have already increased the pressure on banks to slow lending to investors. The last round of macro prudential measures combined with significant negative media publicity at the time worked very well in late 2015/early 2016 in slowing the Sydney and Melbourne property markets and would have kept working if they were tightened again around six months ago when it became clear that the initial impact was wearing off. Sure macro prudential measures are second best to using rate hikes to slow property prices, but in the absence of more fundamental solutions, it’s the best option at a time when its way too early to hike rates given the state of the overall economy and property markets outside of Sydney and Melbourne.
While strong population growth means that underlying property demand remains strong, the threats to the hot Sydney and Melbourne property markets are continuing to build: another round of macro-prudential measures looks to be on the way, with regulators already putting pressure on banks to slow lending to property investors; the banks are raising rates out of cycle particularly for investors (with the CBA and ANZ joining the NAB and Westpac in hiking in the last week); the Federal, NSW and Victorian governments are swinging into gear to improve housing affordability; all at a time when the supply of units is surging; and prices are ridiculous. Expect a significant cooling in price growth in Sydney and Melbourne this year followed by 5-10% price falls commencing sometime in 2018.
Major global economic events and implications
US data was mostly good. Existing home sales and home prices were weaker than expected, but durable goods orders were strong, new home sales surged, jobless claims remain historically low and while the manufacturing PMI fell, it remains solid.
Eurozone business conditions PMIs rose more than expected in March to strong levels and point to a pickup in growth. Consumer confidence rose and is about as high as it ever gets. Europe is looking good for investors, as growth looks set to pick up and this will boost profits, the European Central Bank (ECB) remains very supportive and Eurozone shares are relatively cheap, in part due to overstated fears of a break-up of the Eurozone.
Japan’s manufacturing conditions PMI slipped in March, but remains in a rising trend and continues to point to reasonable economic growth.
Australian economic events and implications
In Australia, official ABS home price data confirmed that the housing market has hotted up again after a soft patch in late 2015-16. Private data points to a further acceleration in the first few months of this year. Sydney and Melbourne remain the main culprits though, with prices still trending down in Perth and Darwin and only seeing moderate growth in other cities. Meanwhile, September quarter data showed an uptick in population growth to a solid 1.5% year on year or 349,000 people highlighting a key source of underlying property demand.
What to watch over the next week?
In the US, there’s no doubt the debate around the failure to reform Obamacare will remain a focus. But in our view it was just a silly distraction and President Trump and Congressional Republicans will just move on to the key elements of his pro-business agenda, notably tax cuts. On the data front, expect to see consumer confidence remaining high and continued growth in home prices (both Tuesday), a bounce back in pending home sales (Wednesday), modest growth in personal spending and core consumption deflator inflation remaining around 1.7% for the 12 months to February (Friday).
Eurozone economic confidence indicators (Thursday) are expected to remain solid and core inflation is likely to have remained unchanged at 0.9% year on year in March.
Japanese data for February to be released Friday is likely to show continued strength in the labour market, strong industrial production but weak household spending and core inflation remaining only just above zero.
The UK will likely trigger Article 50 of the Lisbon Treaty on Wednesday, setting off a two year negotiation process to exit the European Union (EU). There will be a long way to go but the EU is likely to be a tough negotiator.
China’s manufacturing conditions index for March (Friday) is expected to slip back to 51.5 but retain most of its recent gains.
In Australia, expect credit growth (Friday) to remain moderate but the focus will likely be on a further acceleration in lending to property investors. Data on new home sales and job vacancies will also be released.
Outlook for markets
Shares remain vulnerable to a short term pull back, as investor sentiment is very bullish and a lot of good news has been factored in, which has left the market vulnerable to any bad news – as the uncertainty around Trump’s pro-business agenda showed over the last week. However, we would see any pullback as an opportunity to “buy the dips” as valuations are okay, global monetary conditions remain easy and global profits are accelerating on the back of stronger global growth. So shares are likely to continue to trend higher on a 6-12 month horizon.
Still low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds. At present, bond yields are still consolidating after last year’s rise, but a resumption of the bear market is likely at some point in the months ahead seeing a gradual rise in yields.
Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield, but this demand will wane as bond yields trend higher over the medium term.
National residential property price gains are expected to slow to around 3-4% this year, as the heat comes out of Sydney and Melbourne.
Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.
For the past year the A$ has been range bound between $US0.72 and $US0.78 and this may continue for some time yet. At some point this year though, the downtrend in the A$ from 2011 is likely to resume as the interest rate differential in favour of Australia narrows (as the US Federal Reserve hikes three or four times and the RBA remains on hold).