Market fright, Hunt for yield, the Fed Shift, Australia’s credit crunch, and more

Last Night's Markets
Markets Wake In Fright
The Hunt for Yield is Back
The Fed Shift
Australia’s credit crunch
Earnings Recession?
The Good News: China
Platform Diving
New Zealand
InvestSMART’s Portfolio Manager
The “Myths Tour”
Research and Diversions
Facebook Live
Next Week
Last Week

Markets Wake In Fright

Global markets suffered a sudden attack of nerves over the economic outlook last night, with the Global Dow dropping 1.4%, amid quite heavy falls in Europe and the US.

It started in Germany, where the manufacturing PMI (purchasing managers index) dropped to a shocking 44.7, down from 47.6 and versus market expectations of 48 – causing the 10-year German bund yield to go below zero for the first time since 2016.

The Dax index fell 1.4%, while the FTSE in London and the CAC in Paris both dropped more than 2%.

In New York the Dow lost more than 350 points at one stage and all the indexes were off well over 1%, but the bigger news there was that part of US yield curve inverted – that is, the 10-year Treasury bond yield fell below the 3-month bill rate, 2.43% to 2.46%. Yield curve inversion often, but not always, presages recession.

As Dave Rosenberg of Gluskin Sheff wrote this morning, the global bond market is on fire. The 10-year Aussie yield fell to a record low of 1.83%, the yield in New Zealand fell below 2% for the first time ever, bunds in Germany went below zero, and the Japanese bond yield fell 3.5 basis points to minus 0.08%.

As well as the weak PMI, German construction orders in January fell 7.9%. Also the PMI in France delivered a surprise contraction – 49.8 versus consensus at 51.4 – and the broader euro area PMI stayed in contraction mode (below 50) for the second month in a row.

The data are consistent with European GDP growth in the first quarter of virtually nothing – 0.1-0.2% - and it follows the Fed having just downgraded its forecasts for the US economy in 2019, and the Bank of Japan doing the same thing on Wednesday.

Whether this turns into a proper correction probably depends on how quickly central banks respond. You’ll remember something similar happened early last year: some data showed economic weakness, but the Fed stayed in tightening mode and the global MSCI index fell 9% in February, having rallied 7% post-Christmas 2017. The S&P 500 had a proper correction of 11.3%.

This time the post-Christmas MSCI rally has been a whopper – 18% - based on the Fed doing a U-turn and going from tightening mode to pausing for at least 12 months … because of the weak data.

But as always the equity market has been more interested in what the Fed is doing than the data that is behind it, while the bond market is watching the data.

The cash futures market is now pricing in a rate cut, and if equities start doing the same thing there might not be a big correction, but as things stand the sharemarket looks vulnerable, having rallied hard into a clear global growth slowdown.

The other thing that might rescue equities is Chinese fiscal stimulus, as it has in past, although you must wonder how long before even the Beijing treasury is tapped out.

Here’s a cheery quote from the Financial Times this morning: “When bonds rally as much as they have over the last few days you have to suspect there is something much larger going on,” said Tom di Galoma, managing director at Seaport Global Securities. “We are looking at very tepid growth this quarter and it could rapidly deteriorate from there. We could be on our way to another crisis here.”

And of course one consequence of the tumbling bond yields is that the hunt for yield is back …

The hunt for yield is back

No this is not another item about the ALP’s dividend franking policy, although that is part of the story. It’s about central banks, falling interest rates and the new search for income investments that aren’t a risky roll of the dice.

There were two notable central banking events this week: RBA assistant governor Michele Bullock’s speech in Perth and Fed chairman Jerome Powell’s statement following the Fed’s two-day March meeting.

But first some 20-year charts of bond yields.

Australian 10-year bond yield:

US 10-year bond yield:

Aust-US 10-year yield spread:

The Australia-US spread went negative a year ago and has kept going south since then. Currently Australian Government 10-year debt is priced to yield 1.88% while a similar duration loan to the government of the United States of America yields 2.5%. It’s unprecedented, and more than a little bit crazy.

Why is there such strong demand for Australian bonds (causing the price to rise and the yield to fall faster than US yields)? Because of the hunt for capital gain. Bond investors would only accept a lower running yield for Australian debt versus US paper because they think it’s more likely to generate a profit, otherwise why buy it? You’re not doing it for the interest rate carry that’s for sure. After all, both are rated AAA.

That means they must think the Australian yield will go lower from here, in turn because growth and inflation continue to weaken, more than in the US.

The problem is that the bond speculators’ hunt for capital gain is forcing genuine income investors into a hunt for yield, given added urgency by the forthcoming change to dividend franking (see last week’s exhortation on why to wait before taking action on that score).

Normally it would mean bank shares would outperform, since they have traditionally been the main bond proxies in the sharemarket. Except, they have other problems at the moment, such as weak credit growth and a possible tsunami of bad debt provisions, not to mention compensation and remediation payments.

But other, less conventional, bond proxies have outperformed, such as Transurban ( 9.8% year to date, yield 4.4%), Fortescue ( 55.4%, yield 4.8% - although there’s the iron price as well of course), APA Group ( 17.5%, yield 4.6%), Macquarie ( 16.7%, yield 4.2%).

The thing is that bond yields are unlikely to start rising again in the short term: 2019 looks like being a year in which the search for yield returns with a vengeance, and quality yield stocks do well. At least that’s a fairly easy way to make money.

The Fed Shift

The rate futures market is now priced for a 30% chance of a US rate cut this year and a 60% chance of no further hikes. The Fed itself is predicting no change in 2019.

That is a full 180 degrees about face from just three months ago, when chairman Jerome Powell declared that “we have a strong forecast for 2019” and to expect “some further gradual (rate) increases” this year. 

Two days later, Bloomberg reported that President Trump was thinking of firing Powell. Not that the Fed’s change of heart has had anything to do with that, or not that they would admit anyway, and I presume the President has now moved onto other more pressing matters.

But there were two bigger pieces of news in Thursday’s statement than the stuff about interest rates, which was admittedly pretty momentous: there was a significant downgrade to its assessment of the US economy and the announcement that the Fed would stop contracting its balance sheet in September, after slowing the pace of it from May.

Meanwhile the growth outlook has been trimmed from 2.3% to 2.1%, although the forecast range is very wide – 1.6-2.4%. So obviously someone at the Fed thinks growth is going to be a long way sub-2%.

The bond market loved the growth downgrade and the sharemarket loved the changes to monetary policy: the Fed’s decision to stop contracting its holdings of long term securities is good for equities, as is no rate hike in 2019, and there were solid gains on Wall Street the day after the Fed statement after some confusion on day one.

Mind you, a lot of it – perhaps all of it – is in the price already, since the market is on track for its best quarter since the GFC.

What’s more it will all change if the data changes: if inflation starts to move higher in the American autumn, then a rate hike before year-end would be back on the cards and the sharemarket would correct, or worse, and if the Fed turns out to be too optimistic and the economy slips into recession, the sharemarket would correct, or worse.

In other words we are driving along a ridge with steep falls on either side, although I think the road is nice and wide and the danger of either a recession or a rate hike is minimal.

Some are saying that the Fed’s screeching U-turn implies that they know something we don’t know about the US economy, and that they must be really worried. That doesn’t stand up to much scrutiny.

In fact the Fed’s forecasting credibility is not great:

In other words, the Fed has no better idea about what’s going to happen to the economy than anyone else.

Australia's credit crunch

RBA assistant governor, Michele Bullock’s speech on Wednesday highlighted Australia’s special problem. It’s the reason bond yields here falling more than the rest of the world and the sharemarket has been underperforming both the US market and the world MSCI index (by 8% and 5% respectively).

She basically implored banks to start lending again, stating that “the appropriate amount of credit risk is not zero – banks need to continue to lend and that will inevitably involve some credit losses.”

Banks are groggy from two severe beatings, first from APRA and then the royal commission. Best to stay on the canvas, they reckon.

And fiscal policy won’t be coming to the rescue: to ensure they are both seen as responsible economic managers by the electorate, neither major party is proposing to slow down the pace of fiscal consolidation and the timing of the budget’s return to surplus. That might change after the election, but by then it would be too late.

And so the economy is in the grip of an outbreak of responsibility, not to mention irony: a sudden attack of responsible bank lending has produced a credit crunch, and responsible budget management is removing the prospect of fiscal policy to offset it.

It means the RBA is fighting the war on its own, with very little ammunition - begging the banks to be less responsible and eventually forced to cut rates from not much to even less, probably to zero effect.

Nevertheless, the cash rate will probably be 1% by year end, even less if the property market is still deteriorating. Zero rates? Maybe. There is certainly plenty of precedent, and no stigma any more.

Earnings Recession?

For sharemarket investors, it’s going to all about earnings and how the full year results hold up.

Consensus earnings forecasts have been reduced from close to 10% for FY2019 to 3.3% (it’s the green line in the graph below):

One of the key signals for earnings is the yield curve, that is the difference between short and long term interest rates.

A steepening yield curve (long rates rising more than short rates) usually foreshadows earnings upgrades for domestic stocks because it signals a positive economic outlook, and vice versa – flattening curve presages downgrades. And a negative one – inverse – usually heralds a recession.

Here’s a chart of one measure of the yield curve – the 10-year bond yield minus the cash rate, since the start of last year:

As you can see it has flattened considerably since November which did, indeed, herald earnings downgrades.

The Morgan Stanley note from which the above earnings consensus chart was taken concluded that “an industrial earnings recession looms”.

“When breaking down the outlook for the ASX200’s three super sectors (financials, resources, industrials) our models suggest an earnings recession is likely for the non-resource sectors as domestic factors weigh. Prior earnings recessions, while relatively common for Australia, have predominantly been linked to the resource/global growth cycle.

“We think the domestic-led nature of the next likely episode of earnings weakness will increase the depth and length of the downturn.”

Which is what the bond market is telling us.

The Good News: China

All of the above is a bit gloomy, I admit, but that’s just how it is. The good news is that China is looking better, so the mining and energy sectors, at least, will head into the second quarter in decent shape.

Macquarie’s China Business Cycle Indicator has a good record of predicting both the state of the Chinese economy and ASX mining stocks’ performances.

As you can see, the indicator tanked in the second half of last year, contributing to the equities correction. But in mid-December it turned around hard, and as a result the Resources Index has outperformed the ASX200 by 10% (up 21% versus 11%).

Basically it means the rally in mining stocks is supported by fundamentals and, at this stage, they don’t look overbought.

Platform Diving

Interesting announcement this week by Westpac to sell its financial advisory business to Viridian, but not sell its platform, Panorama. I don’t think that decision will last – the platform will go too.

The big losers are the Westpac subsidiary, BT and its Panorama platform, as well as the rest of the big four and AMP. It’s not just industry funds that have caught a windfall from the royal commission, but the independent platform operators as well.

According to Citi there has been a $5 billion transfer from the big four and AMP to the independents over the past 12 months. BT and AMP are still the largest, but not for long.

So it makes no sense that Westpac didn’t get out while it was ahead. I guess like all big bureaucracies, it will wait till the business is really on its backside before selling for a lot less.

By the way, Hub24, Netwealth, and Praemium are all listed companies and none has done all that well in share price terms lately, while killing it in the investment marketplace.

New Zealand

Two long-term consequences of the shocking massacre in Christchurch last Friday, one of which has some relevance to investors: first, assault weapons have been banned, instantly, rather showing up America; and second, global attention has focused on social media, and specifically Facebook.

Maybe the outrage at Facebook’s failure, or inability, to take down the murderer’s film of what he was doing will peter out, but there must be a chance that social media platforms will soon be regulated like the utilities that they are.

So far they have avoided that by calling themselves technology companies at the cutting edge of laissez faire capitalism etc.

But of course they are nothing but near-monopoly utilities providing a fundamental service (I hesitate to call them essential services, but maybe some people would).

Anyway, if this isn’t the turning point in how these businesses are viewed, something else will be. The evidence is mounting that some kind of controls on how these platforms are used by all and sundry, including very unsavoury people, is inevitable in my view.

The result will be lower profit margins, because at the moment they are supported by the lack of human curation – it’s all algorithmic which, as we’ve seen this week, is far from perfect.

So in my view we are in the midst of peak open slather on social media, and therefore peak profits.

InvestSMART’s Portfolio Manager

One of the best things about InvestSMART is the free portfolio manager. It’s good, one of the best in the market, and it’s free!

If you’re interested in learning more about it – and I really think you should if you don’t use it already – there’s a webinar on the subject next Tuesday, March 26, at 1pm, conducted by Mitch Sneddon.

You can register for it by clicking here.

The “Myths Tour”s

Videos and slides from our sold-out series of presentations entitled “Myths That Can Hurt Your Wealth” have been uploaded on the InvestSMART website.

You can access them here, and here's one presentation from the session, but there's several more including a full panel Q&A.

Myth: Higher fees mean higher returns and fees are too small to even matter:

Research and Diversions

Research

The Boeing 737 crashes raise tough questions about automation. This is very interesting. President Trump tweeted something about this, but he might be onto something.

Every airplane development is a series of compromises, but to deliver the 737 Max with its promised fuel efficiency, Boeing had to fit 12 gallons into a 10-gallon jug.

Here is why AI has yet to reshape most businesses – because it’s slower and more expensive than it might seem.

Why tech didn’t stop the New Zealand massacre video from going viral. Because they don’t use human beings to make decisions, and “they haven’t gotten to the point of having effective AI to suppress this kind of content on a proactive basis, even though it’s the most cash-rich [...] industry in the world.”

A mass murder of and for the internet. Good piece in the New York Times.

White nationalism, born in the USA, is now a global terror threat.

Why capitalism isn’t working for millennials. “…because they have had to adjust their entire definition of what a ‘good life’ is or what living with prosperity and freedom means. When having a family isn’t affordable and when your society isn’t prioritizing the kinds of things that allows you to bring a new being into this world with a good conscience. When your most powerful leaders are ignorant to things like global warming, or gender equality or the problems of wealth inequality that are making us less trustful of this capitalism construct.”

A good guide to all of the ASX-listed cannabis stocks.

A future without fossil fuels? “Based on earlier technological transitions—horses to cars, sails to steam, land lines to cell phones—it seems possible that the fossil fuel industry may begin to weaken much sooner than you’d think.”

An interesting speculation about life with fully automated home delivery. In particular, the “tide of packages is unlikely to recede. Technology giants with multibillion-dollar research budgets are working to further embed our everyday lives within an ecosystem of accumulation, assuring that those packages will keep coming.”

Trump has proposed a sort of 5G NBN wholesale network for America. “The twist? Open access wireless is actually a terrific idea. The concept, promoted by Republican operatives such as Newt Gingrich and Karl Rove, is for a network supporting fifth-generation (5G) wireless technology to operate on a wholesale basis.” 

Recession, blockchain, drones and other tech predictions for 2019. Summary: there will be more tech, lots more.

Tim Boreham: Amid the rush by the ASX listed ‘pot stocks’ to grow medical cannabis, the market has overlooked a key question: where will all the therapeutic hooch be processed?

Here’s someone who is all in favour of Modern Monetary Theory, and explains it in a different wayto any that I’ve read so far. “Unlike the generalised impact of interest rates, tax and investment based interventions can be targeted at particular sources of inflationary pressure. For instance, if land prices are shooting up then an appropriate response might be the imposition of land value taxation to dissuade speculators.”

Facial recognition technology: what would George Orwell say? I told you so, I suppose.

Bigger LIC discounts than usual. As the markets have recovered, most LICs have lagged that recovery. While the NTA’s have increased somewhat, LIC prices have not increased by nearly as much and the discount has widened.

A submission to the Australian Treasury on Initial Coin Offerings. “We believe it’s critical for people to better understand what really happened during this mania, the skewed incentives that resulted and the ramifications of this blind excess. The ultimate aim is to help ensure something this deranged does not happen in a space with so much promise. This is an expose.”

“Workism” is making us miserable. Well, it says Americans, but it could be us too. “The economists of the early 20th century did not foresee that work might evolve from a means of material production to a means of identity production. They failed to anticipate that, for the poor and middle class, work would remain a necessity; but for the college-educated elite, it would morph into a kind of religion, promising identity, transcendence, and community. Call it workism.”

Quit worrying and learn to love trade with China. “If we import more from China than we export to China, we make up the difference with engraved portraits of Ben Franklin that cost 12.5 cents each to print. For one of Ben’s portraits we get $100 worth of computers. Pretty good, eh?”

Here’s what Disney owns after the massive merger with 21st Century Fox.

Diversions

The world’s best chocolate cake recipe, not that we need it.

A brief history of why artists are no longer making a living making music. “By the late 70s, the industry was fat, corrupt and complacent. It was also very expensive to make a recording in the beautiful studios of the world.”

A good essay by the Guardian’s Katherine Murphy, in Meanjin, on the state of Australian politics. “Last year was a gruelling one in Australian politics. The despair of the representative class was sometimes sufficient to brim, then spill from the parliamentary precinct.”

On Yuval Noah Harari. His book “Sapiens” is our book club book for next month, so I’m reading up on him a bit, as well as reading the book of course. This piece is good.

This masochist has read all of the memoirs of the candidates for US President in 2020. "Each one is so uniquely unintelligible that, in the end, it doesn’t even make sense to compare them." 

The house that inspired Wuthering Heights is for sale.

Why do we hate decaf coffee? When everyone’s having gluten free, and veganism is taking off, why isn’t decaffeinated coffee also taking off? Well, because “caffeine is basically fine”.

Disney as the custodian of American culture. “Disney’s weird. It’s kind of a company, but also custodian of some of the cultic functions of American culture, something like the priestly colleges of ancient Rome. Like, they maintain sites of pilgrimage. I’m not saying that as a joke. Americans go to Disney parks at a rate 7 times higher than Muslims go to Mecca.

15 surprising facts about frozen food. For example: Clarence Birdseye revolutionised frozen food. Yep, that was his name.

Italy faces olive oil crisis as climate change and disease cuts harvest by a record 57%.

Where did it all go so wrong? An Arab veteran of the anti-Soviet jihad speaks. “The Muslim world can easily find martyrs but what it urgently and desperately needs are statesmen, negotiators, advisors, scholars, and intellectuals who understand their times and peoples.”

How China censors novels. “One man told the South China Morning Post his editors deleted the number 64 from his story. The number, of course, corresponds to the date of the Tiananmen Square crackdown that took place on June 4, 1989.”

What is it about caves that’s so interesting? Here are 14 exceptional caves.

Happiest of happy birthdays to long-dead but not forgotten Johann Sebastian Bach, born March 21st, 1685. I think my two favourite players of Bach are Glenn Gould and Jacques Loussier, who plays Bach as jazz.

First here’s Glenn Gould doing Chromatic Fantasia in D minor. Just incredible.

And here’s the Jacques Loussier Trio doing Toccata and Fugue in D minor. I have been listening to this, and everything Loussier does, off and on for 35 years. It’s like putting on a comfortable but dazzling coat.

And in case you’re not a jazz fan, here the Toccata and Fugue played on a big organ, as JSB intended.

And here’s Google’s celebration of Bach’s birthday. It’s pretty good.

Happy Birthday Harry Vanda, lead guitarist of The Easybeats, 73 yesterday. How good was Friday On My Mind?

It was also Andrew Lloyd Webber’s 71st birthday yesterday. Not really my cup of tea, although he wrote a pretty good Pie Jesu for his Requiem.

I ate some pie

Facebook Live

If you missed #AskAlan on our Facebook group this week (or if you don’t have access to Facebook) you can catch up here. And there's also the Facebook Livestream page where you can also opt to just listen to the questions and answers.

If you’re not on Facebook and would like to #AskAlan a question, please email it to askalan@investsmart.com.au (new email!) then keep an eye out for the Facebook Live video in next week’s Overview.

Next Week

By Craig James, Chief Economist, CommSec.

Australia: Quiet week with focus on ‘second tier’ data

• In the coming week economists will likely be doing early preparations for the Federal Budget. Because clearly there isn’t too much in the way of influential economic events.
• The week kicks off on Tuesday with a speech from Luci Ellis, Assistant Governor (Economic), at the Housing Industry Association March Industry Outlook breakfast.
• Clearly housing issues are very much centre-stage at present, especially the correction of housing activity and home prices underway in Sydney and Melbourne.
• Also on Tuesday, the regular weekly reading on consumer confidence is published by ANZ and Roy Morgan.
• Recently, confidence has been volatile from week-to-week but the actual index of confidence isn’t far away from longer-term averages. So consumers aren’t gloomy, more ambivalent.
• On Wednesday the focus is on ‘panel participation’ by Christopher Kent, Assistant Governor (Financial Markets) at the FX Week Australia event in Sydney.
• Also on Wednesday, the Australian Bureau of Statistics will release data on regional population growth for the 2017/18 year. The ABS also releases December quarter figures on engineering construction. A boom in infrastructure spending is underway so the latest ABS data will put the spotlight on how much activity remains to be completed.
• On Thursday, the ABS releases detailed estimates on the job market for February. The data will include industry estimates of employment. Job vacancies data is also released – currently at record highs.
• Also on Thursday, the ABS releases the ‘Finance and Wealth’ estimates for the December quarter. The figures include data on household wealth – likely to show a fall, but this is also likely to be partially reversed in the current quarter given the strong sharemarket.
• On Friday, the Reserve Bank releases the ‘Financial Aggregates’ publication, including the latest money supply and lending aggregates. The Australian Prudential Regulation Authority (APRA) also issues the February data on bank deposits and lending, including credit card data.

Overseas: US inflation & growth in focus

• Key US economic growth and inflation measures are the key interest points in the coming week.
• The week begins on Monday in the US when the Chicago Federal Reserve national activity index is released with the Dallas Federal Reserve manufacturing index.
• On Tuesday in the US, it’s a big day for new information on the housing market. The February figures on building permits and housing starts are released. Also the S&P/Case Shiller home price index is issued with the FHFA measure on home prices. The March reading of consumer confidence is also issued with the influential Richmond Federal Reserve manufacturing index. The usual weekly data on chain store sales is also scheduled.
• The S&P/Case Shiller measure of home prices stood 4.2 per cent higher than a year ago in December – a four-year low and down from the 4.6 per cent annual gain in November.
• Housing starts posted a huge 18.6 per cent lift in January so the February data is likely to show some retracement.
• On Wednesday in the US, the January international trade data is issued. In December the deficit widened from US$50.3 billion to US$59.8 billion. The trade deficit over 2018 was at a 10-year high.
• Also on Wednesday in the US, the broader December quarter current account data is released with the weekly measure of mortgage applications.
• On Thursday in the US, the final estimate of economic growth for the March quarter. The initial estimate was put at a 2.6 per cent annual rate. But the thinking is that the growth estimate may be revised down in light of the widening of the trade deficit revealed for December.
• Also on Thursday in the US, the usual weekly data on claims for unemployment insurance is released with pending home sales and the Kansas Federal Reserve manufacturing index.
• On Friday in the US, personal income & spending data will be released with the Chicago purchasing managers index, weekly consumer sentiment and new home sales.
• Most interest is in the income and spending data. But not specifically for those measures, but rather the accompanying inflation data. The core personal consumption deflator is the Federal Reserve’s favoured inflation measure. Annual inflation sits at 1.9 per cent – below the 2 per cent target.
• There are also no fewer than 11 talks from US Federal Reserve officials to watch over the week.
• In China, the only real interest will be in the January/February data on industrial profits – due for release on Wednesday.

Last Week

By Shane Oliver, Head of Investment Strategy and Chief Economist, AMP Capital.

Investment markets and key developments over the past week

• While Eurozone shares fell slightly, other major share markets rose over the last week helped by Fed dovishness. From their December low US shares are now up 21%, global shares are up 18% and Australian shares are up 14%. The underperformance of Australian shares in the rebound since December reflects the fact that they didn’t fall as much in last year’s share market slump and because the growth slump locally has weighed more on earnings expectations for Australian shares. Meanwhile bond yields continued their trend down over the last week, commodity prices were mixed with oil and gold up but copper and iron ore down and the $A rose slightly against a flat $US.
• How can shares rally and bond yields decline at the same time? Who is wrong? This is not unusual. The same occurred in 2016 with shares bottoming around February and bond yields not bottoming till around July/August. Its often referred to as being the “sweet spot” in the cycle where shares rebound from being undervalued and as investors start to anticipate stronger growth helped by easier central banks, but bonds are still responding to news of low inflation and expectations of lower interest rates for longer. This is exactly what we are seeing now. Bond yields may still have more downside but are likely to push up in the second half as global growth improves. 
• Fed even more dovish both on rates and quantitative tightening. As expected, the Fed left rates on hold at its March meeting and while it revised down its growth forecasts a little bit it remains upbeat on the outlook and sees inflation staying around target. Consistent with its dovish tilt in January and inflation around target, the Fed remains “patient” on rates, its dot plot of rate hike expectations has been cut to no hike this year (from two hikes seen in December) with just one hike remaining next year and it has signalled that it will start slowing its balance sheet reduction (or quantitative tightening) from May and end it in September. In essence the Fed sees growth around potential, inflation around target, unemployment around NAIRU and rates around neutral so there is less pressure to do anything. So for now the Fed remains far less threatening for markets, but as we saw after a similar dovish tilt back in 2016 a return to a slightly more hawkish stance is a risk for later this year if as we expect US growth picks up again against the backdrop of a still tight labour market.

Source: Bloomberg, AMP Capital

• Getting closer to a US/China trade deal, but does this mean that Trump would open up a new trade war starting with auto tariffs on Europe? The past week saw ongoing argy bargy around US/China trade negotiations particularly around when the US would remove the tariffs on imports from China but this is to be expected. But a deal still looks likely as its in both sides interests and Trump continues to say that “the deal is coming along nicely”. But a deal with China would beg the question of whether Trump will then turn his attention to trade with Europe starting with auto tariffs. However, even though the Commerce Department is reported to have provided a rationale for tariffs to be imposed on auto imports on “national security” grounds and this may cause some market angst as Trump has to mid-May to decide to or not, our assessment is that he probably won’t: the Commerce Department report looks like a negotiating stance with Europe; America’s trade deficit with Europe is small compared to that with China; public and Congressional support for a trade war with Europe is low; most of Trump’s advisers are against it; the EU would retaliate and this would badly affect states that support Trump that export to Europe; it would be a new blow to confidence and share markets ahead of Trump’s 2020 re-election campaign.
• The Brexit comedy rolls on with the European Union giving PM May up until April 12 to get her Brexit plan passed through the UK parliament on a third go (probably in the next week) or to seek a longer extension. While pressure on Brexiteers to support the deal is now intense it’s still far from assured that it will receive parliamentary support. If it doesn’t, then the EU – not wanting to be blamed for a no deal Brexit - will likely accept a request for a longer extension, but it would probably be conditional on the UK voting in EU parliamentary elections in May, and it would likely mean that the whole thing could drag on for another year! Our view remains that a soft Brexit or no Brexit remains most likely but it’s a long way from being resolved. Because 46% of UK exports go to the UK but only 6% of EU exports go to the UK Brexit means far more for the UK economy that it does to the EU! What happens in the Eurozone is far more significant to us as investors than what happens with Brexit.
• The Australian Federal Budget to be handed down on April 2^nd will have three obviously overlapping aims: to provide a fiscal stimulus in the face of flagging growth; to reinforce the Government’s budget management credentials by keeping the budget on track for a surplus in 2019-20; and to help get the Government re-elected in a most likely May 11 or 18 Federal election. In all of this it has been helped by a revenue windfall mainly due to higher corporate tax receipts on the back of higher commodity prices (partly due to Vale’s problems in Brazil) but also higher personal tax collections due to stronger employment growth and lower welfare spending partly offset by reduced growth forecasts for 2019-20 and 2020-21. This is likely to see the budget running around $5bn better than expected in the December MYEFO for 2019-20. However, given the need for a fiscal boost and pre-election sweeteners the Government is likely to “spend” the bulk of the revenue windfall. We expect around an additional $3bn in personal tax cuts which along with the roughly $3bn pa already allocated for tax cuts in December’s MYEFO and the $3bn already legislated for following last year’s budget is expected to result in total personal income tax cuts of around $9bn from July – which are likely to be skewed towards low- and middle-income earners. There is also likely to be extra spending on health and infrastructure. Key Budget numbers for 2019-20 are expected to be: a budget surplus of around $5bn after budget handouts (or $10bn before any stimulus), real GDP growth of 2.5%, inflation of 2.25%, wages growth of 2.75% and unemployment of 5%.
• The upside of the Australian Government’s Budget strategy is that the household sector will receive a boost just at the time it needs it given falling house prices and likely rising unemployment and of course a budget surplus is at last coming into sight after a record 11 years in deficit. The downside is that the tax cut boost to the household sector will like be small at around 0.5% of GDP, there is less assurance of a boost to the economy from tax cuts as opposed to “cheques in the mail” or increased government spending, the election means greater uncertainty about whether and when the stimulus will actually be delivered and the budget projections will come with a high level of uncertainty as the revenue boost from higher iron ore prices may prove temporary and slower economic growth will weigh on revenue. The stimulus is unlikely to be enough to head off the need for RBA rate cuts.

Major global economic events and implications

• US data was mostly positive adding to the view that while the March quarter may be weak, growth is likely to bounce back up again. A home builders conditions index was flat in March but current sales and expectations improved, manufacturing conditions in the Philadelphia region improved in March, the leading index rose more than expected in February and jobless claims fell.

Australian economic events and implications

• Australian jobs data added nothing to the debate about whether to cut rates or not. Unemployment fell, but this was due to reduced labour market participation. Employment slowed but this was after a huge surge in January so could just be noise. That said skilled job vacancies fell again in February consistent with falling ANZ job ads in pointing to slower jobs growth ahead. And the labor market is a lagging indicator. We see unemployment rising to 5.5% over the next year. There was a bit of good news with a rise in the CBA’s composite business conditions PMI for March, but this looks like normal volatility and at a reading of 50 it remains very weak.
• Population growth remains strong – good for growth and good for underlying housing demand, but remember the focus should be on growth in GDP per person because that is more relevant for living standards. ABS data showed that population growth remained unchanged at a strong 1.6% over the year to the September quarter with 1 percentage point of that coming from migration and the rest from natural growth. Strong population growth naturally helps support demand in the economy and is a source of support for house prices (although a bunch of negative factors are dominating in the short term). But it also means that in Australia we have to have GDP growth in excess of 1.6% pa to grow GDP per person, whereas in Europe its just 0.2% and in Japan its -0.2% to do the same.
• Why will limiting negative gearing and halving the capital gains tax discount push up rents and push down property prices? Several studies have looked at this issue with similar conclusions since it became part of Labor Party policy in 2016. The answer is quite simple. If negative gearing is limited and capital gains tax increased then investors will demand a higher pre tax return to invest in property. Looked at in rental yield terms (ie annual rents divided by prices) SQM Research – after examining international comparisons, what the tax changes would mean financially to taxpayers and the 1985-87 experience when negative gearing was briefly removed - estimate that rental yields are likely to rise around 1 percentage point over a 2-3 year period if the tax changes are made. This would occur via less investor demand in the property market causing some combination of lower property prices and rising rents (partly due to less property construction) until it becomes attractive to invest in property again. On their estimates average capital city property prices would fall 4 to 8% (but fall 7 to 12% in Sydney and fall 8 to 13% in Melbourne) and rents rise 7 to 12% in response over 3 years. Now this assumes two interest rates cuts and if that doesn’t occur the estimated fall in property prices is 5 to 12% relative to what otherwise would have occurred. A study last year by Riskwise Property Research and Wargent Advisory reached similar conclusions in terms of prices. Of course other things could reduce this impact like a new first home owners grant scheme and if rental yields have already increased anyway. Would property investors rush into to the market ahead of the changes if they are confirmed so they can be grandfathered? Maybe. But they may also decide not to because they would worry that their investment property will be worth less once the tax changes occur. Regardless of the merits of such changes (for the record I think there is a strong case to reduce the capital gains tax discount but am less sure about the proposed change to negative gearing), this issue is another drag on the residential property price outlook.

What to watch over the next week?

• In the US, data releases are expected to show a fall back in housing starts after January’s surge, but continued modest gains in home prices and a slight further rise in consumer confidence (all due Tuesday), a slight improvement in the trade balance for January (Wednesday), a downwards revision to December quarter GDP growth (Thursday) from 2.6% annualised to 2.4%, a fall in pending home sales (Thursday) but a rise in new home sales (Friday), a modest gain in January consumer spending (also Friday) along with core private consumption deflator inflation staying at 1.9% year on year.
• Eurozone economic confidence data for March to be released Thursday will be watched for signs of stabilisation after falling over the last year and core inflation (Friday) is likely to have remained stuck around 1%yoy.
• Japanese jobs data for February (Friday) is likely to have remained strong but industrial production is likely to bounce.
• In Australia, ABS job vacancy data for February due Thursday is expected to show some signs of softening consistent with the ANZ job ads survey, and private credit growth (Friday) is likely to have remained modest in February with housing investor credit remaining weak. Public addresses by RBA officials Ellis and Kent on Tuesday and Wednesday will be watched for any clues on the interest rate outlook.

Outlook for investment markets   

• Share markets – globally & in Australia - have run hard and fast from their December lows and are vulnerable to a short-term pullback. But valuations are okay, signs of improving global growth are emerging, monetary and fiscal policy has become more supportive of markets and the trade war threat is receding all of which should support decent gains for share markets through 2019 as a whole.
• Low yields are likely to see low returns from bonds, but they continue to provide an excellent portfolio diversifier. Expect Australian bonds to outperform global bonds.
• Unlisted commercial property and infrastructure are likely to see a slowing in returns over the year ahead. This is particularly likely to be the case for Australian retail property.
• National capital city house prices are expected to fall another 5-10% into 2020 led again by 15% or so price falls in Sydney and Melbourne on the back of tight credit, rising supply, reduced foreign demand, price falls feeding on themselves and uncertainty around the impact of tax changes under a Labor Government.
• Cash and bank deposits are likely to provide poor returns as the RBA cuts the official cash rate to 1% by year end.
• The $A is likely to fall into the $US0.60s as the gap between the RBA’s cash rate and the US Fed Funds rate will likely push further into negative territory as the RBA moves to cut rates. Being short the $A remains a good hedge against things going wrong globally.