Risk and Uncertainty, Mr Powell Sees The Light, Tipping Points, and more

Last Night's Markets
Risk and Uncertainty
Mr Powell Sees The Light
The Josh and Phil Show
Tipping Points
The Climate Change Tipping Point
Research and Diversions
Ask Alan
Next Week
Last Week

Last Night's Markets

Risk and Uncertainty

The word “risk” appeared 26 times in the Federal Reserve Board minutes of the June meeting, released this week, and the word “uncertainty” 22 times. Chairman Jerome Powell then uttered “uncertainties” four times in his testimony to Congress on the same day.

That’s probably about all you need to know about this week’s Fed action: they’re still holding to a “baseline outlook” that involves “solid” economic growth, “strong” labour market and inflation moving back to 2% over time, but, oh boy, the risks and uncertainties are mounting up. Just count them.

The minutes and testimony were very dovish indeed. Next stop, one imagines, is that the “baseline outlook” gets ditched, and something less solid and strong takes its place.

If so, not only will a 50 basis point cut come back on the table, having been taken off the table by futures punters last Friday after those very solid payroll numbers, but the Fed will be heading back to zero interest rates and quantitative easing. 

After all, if you’re fighting a recession with a starting point of 2.25% cash rate, then you haven’t got far to go down. And the RBA, let’s face it, has even less far to go, with a cash rate of 1%.

So far the sharemarket, both there and here, has shown no interest in the deteriorating outlook and has eyes only for the easing Fed, which is par for the course.

Thanks to falling bond yields, price earnings multiples are rising faster than earnings forecasts are falling. In fact, in the US earnings forecasts are not even falling yet, although that situation surely can’t last.

Here’s a chart of the S&P 500 next twelve months (NTM) PE ratio (that is, based on 12-month earnings forecasts). As you can see, not a particularly challenging PE multiple, but the question is whether those earnings forecasts will survive the risks and uncertainties outlined by Mr Powell.

Source: Morgan Stanley

The Australian market is a little more expensive – not because the market has been running hotter than Wall Street, but because earnings forecasts are weaker (or more realistic, take your pick):

Source: Minack Advisers

Both markets are at record highs because of easing monetary policy and falling bond yields, and despite weakening economies.

If falling interest rates can be combined with no recession, then that is a golden combination for the stockmarket. There might be a correction caused by a word out of place from the Fed, some new atrocity by President Tweet, but a bear market is very unlikely without a recession, especially with central banks manning the pumps.

Bear markets are caused by recessions, and recessions are caused either by central banks or external shocks. The next one will definitely not be caused by the Fed or RBA – they’re both doing their level best to make sure they don’t cause one – so external shock it is, or not, as the case may be.

Here are the usual suspects (on which more later):

1. Cold trade war between the US and China
2. War with Iran
3. Collapse of Europe’s banks, starting with Deutsche Bank
4. Brexit
5. Climate change

You probably choked on that last one, because you think it’s a long way off and, according to certain elements of society, a load of rubbish anyway.

Well, it’s not rubbish and, as I’ll explain in a later item (below) the effect on investment portfolios is not necessarily all that far off.

Mr Powell Sees The Light

I think the key statement by Fed chairman Jerome Powell came on the day of his testimony, on Thursday, when he said: “The relationship between unemployment and inflation became weak about twenty years ago. It's become weaker and weaker and weaker.”

I reckon that three “weaker’s” adds up to “broken”, but he didn’t go that far. Nevertheless, it is the single most important fact about markets and investing over the past decade, and the next decade. 

It’s something I’ve been banging on about for years, that the Philips Curve, on which central banking practice is based, is not and never has been some kind of law of nature that is always constant, like the second law of thermodynamics or something.

The Phillips Curve was developed by Kiwi economist WS Phillips in the 1950s, and states that inflation and unemployment always have a stable and inverse relationship.

It supposedly looks like this:

Except it doesn’t, at least not always. It got knocked off course with the stagflation of the 1970s (high unemployment and high inflation) and got smashed about 20 years ago, as Mr Powell now acknowledges, by globalisation and technology (low inflation and low unemployment).

Economists will accuse me of gross over-simplification, but here goes anyway: the 1970s were a shocking time for investors - basically a decade-long bear market with no relief. The opposite outcome applies to the opposite.

Here’s a chart of the S&P 500 from January 1, 1969, to mid-way through 1979:

And here it is over the past 10 years:

The picture tells a thousand words, wouldn’t you agree? 

By the way, the chart of the Australian All Ordinaries index (capital plus dividends) looks much the same as the S&P 500 - the gain over 10 years is 200%.

It’s true that a large part of that 263% bonanza on the S&P 500 has been all about technology (the Nasdaq is up 450% because of Amazon, Facebook, Google, Netflix etc) but that’s exactly the point.

A large part of the reason that the relationship between unemployment and inflation became weaker 20 years ago, as Jerome Powell said on Thursday, is that a technological revolution broke it. That was after China’s entry into the global trading system in 2001 weakened it.

The question, of course is: where to now? It’s been a marvellous decade – how long can such good times last?

I really don’t know – wish I did. The unknown is whether Mr Phillips’ 60-year-old idea will reassert itself – that is, that there will high unemployment (recession) to go with the low inflation.

On balance, I don’t think so. I’m not suggesting there will never be another recession, either US, Australian or global, far from it! But at this stage, labour markets remain fairly strong despite weakening activity.

The risk overhanging everything, in my view, is debt, although in some senses it’s both a positive and a negative. Positive in the sense that it’s part of the reason central banks are keeping interest rates low – to prevent mass bankruptcy, of households and governments.

But the fact that global debt is 220% of GDP (US$244 trillion) and Australian total debt is 250% of GDP ($4.6 trillion) makes everything much more fragile and vulnerable to shocks. 

Our investment portfolios may be less robust and secure than they were in 2007, when there was much less debt – even though, as we learned, they were very vulnerable indeed to a US housing bust.

So what are the risks that could bring things unstuck?

For that, let’s turn to my favourite grizzly bear, Dave Rosenberg of Canadian broker, Gluskin Sheff (he puts out an – expensive – daily note). A couple of days ago he listed his six main risks:

1. Escalating trade tensions – I’m already concerned over the contraction in global trade flows and disruptions to global supply chains. We have a President that doesn’t understand that trade deficits equate capital account surplus, and lacks an appreciation of what it means and how the USA benefits from being the world’s reserve currency. We have a tentative trade truce now, but Beijing has already said all bets are off until all tariffs are removed. And Donald Trump likes to call himself the “tariff man”. I see little chance of a resolution. And keep an eye on the tech trade war underway between Japan and South Korea. (I would just add to Dave’s words that it’s the 75th anniversary of Bretton Woods, the 1944 conference that set up the co-operative trading system that Trump is endangering).
2. Iran’s breach of its enrichment caps – this is a major big deal geopolitically.
3. Will the Fed cut rates and then signal that it’s just an “insurance cut”? This is a big risk – moving too slow when the inflation data are so muted.
4. A no-deal Brexit is a big concern – and whoever leads the Conservatives that seems to be a rising prospect. Th October 31 deadline is not that far away.
5. Jay (Jerome) Powell gets fired or demoted – people tend to forget that the President can take swipes all he wants, but Powell is just one vote. T is a whole committee. What if the whole FOMC decides to resign? What if Jared Kushner becomes the next Fed chairman, or worse – Larry Kudlow? This is a serious risk – that Arthur Laffer could compare monetary and fiscal policy is absolutely incredible. It’s like comparing a cactus to a hotdog. Gold will surge if anything happens on this front, but Trump will get the weak dollar he so desperately covets.
6. The 2020 election – this is not going to get resolved for another 16 months and while the President remains wildly popular among his base, his approval rating is a dismal 40%. And this is coming off the peak of the economic expansion, and the stockmarket and the low unemployment rate. Meanwhile the only reason we have such a wide field of Democratic candidates is that they each smell a huge opportunity. Yet the vast majority are left-of-centre and the only centrist is seen as too old and gaffe prone to make the cut.

Never mind the trade frictions with China, if you are a US business today, all you see are these Democrats threatening to roll back at least some of the corporate tax cuts. So what do you do? Wait and see what happens, which means cash gets built up on the balance sheet instead of getting deployed in the real economy. The surge in the NFIB index in June, and pullback in capital spending and business expansion plans spoke volumes in that respect.

Look, I think half of those are a stretch (specifically 3, 5, and 6), but they’re interesting anyway. Numbers 1, 2 and 4 are clearly real, although a no-deal Brexit is probably not a global worry, and may not even be a British worry. I have a sneaking suspicion it’s a bit like the Y2K bug.

A final note on this subject: The AFR had an arresting write-off to a story on its home page yesterday. “Pump and crash: Why Powell's rate cut could be the "trigger for a recession rather than insurance against it".

Hmm. Naturally, I read on. That sentence was from a quote provided to the reporter, Jacob Greber, by “Washington-based investment adviser, Michael K. Farr”.

He said: “My concern [not prediction, but concern] is that a July rate cut in the face of a still healthy economy will create the exuberance and bubbles from which crashes, and crises, arise," said Washington based investment advisor Michael K. Farr.

"Rather than expecting monetary stimulus to generate more business investment, it's more realistic to think that interest-rate cuts will cause higher asset prices and more debt."

"Recessions are caused by financial imbalances and a rate cut could be the trigger for a recession rather than insurance against it."

In other words, another rate cut could inflate a bubble that would eventually crash. Not a prediction, you understand, but a concern.

Yep, it was a beat-up. 

The Josh and Phil show

There was a rather bizarre photo op on Thursday featuring the Treasurer, Josh Frydenberg, and the Governor of the Reserve Bank, Philip Lowe.

I haven’t seen a video of the event and nor could I find one, but there were some photos of happy smiling faces and a transcript on the Treasurer’s website. 

The transcript starts with 471 words of guff from Frydenberg and then this from the Governor:

“Thank you, Treasurer for the discussions today. I agree 100 per cent with you that the Australian economy is growing and the fundamentals are strong. The outlook is being supported by our lower interest rates, by your tax cuts, by higher levels of investment in infrastructure, by a pickup in the resources sector and the stabilisation of the housing market in Sydney and Melbourne. But I don't think we should forget that more Australians have jobs today than ever before in Australian history. That's a remarkable achievement. And I also agree with you that a priority is to make sure that Australia remains a great place for businesses to expand, innovate, invest and employ people and I'm sure we can do that.”

How nice. So much better than that awkward photo op with Ken Hayne a while ago when the royal commissioner handed over his final report and refused to shake hands with Josh.

But really: if the fundamentals are so strong, Dr Lowe, why is the cash rate 1%? And if the best we can say about the labour market is that “more Australians have jobs today than ever before in Australian history”, then we’re in trouble. There are more people in Australia than ever before in history, so of course there are more people employed!

Can you imagine Jerome Powell or Mario Draghi doing something like that? No, I can’t either.

Tipping Points

I gave a speech this week at a conference run by the Energy Efficiency Council aimed at telling businesses about what’s going on in the electricity business, and how they need to get ready for the transition to solar.

I gave a fair bit of thought to the speech and did some research, and came to a stunning realisation: solar power is in the process of making coal generation uneconomic, and it could happen more quickly than anyone thinks.

I showed this chart of sources of electricity supply through the day, from an AEMO report:

Basically, solar – both rooftop and grid-scale – is already driving more expensive coal and hydro out of the National Energy Market during day-light hours.

One of the people I chatted to at the conference told me that at least 1 gigawatt of solar is being added every year, and that the daytime price of power is consequently being driven towards zero.

It could be like that old quote attributed to Mark Twain (or was it Ernest Hemingway?) about going broke: “How did I go bankrupt? Two ways. Gradually, then suddenly.” In other words, a tipping point gets reached after which things happen fast.

What I mean is that, with solar already swamping coal-fired supply during the daytime, before too long it will take over the daylight hours entirely. Australia’s fleet of coal and gas generators will be quite uneconomic if they can only sell into the NEM at night.

If the coal generators are losing money, with little or no prospect of turning that around since the solar PV is in place and won’t be taken away, then their owners will close them, whether they’re still in good shape or not (many are not in good shape, in fact one in Victoria broke down this week).

Unless a lot of new storage is built rapidly, to shift power from lunchtime to dinner time, the supply of electricity at night is likely to collapse as coal generators close down, especially on still nights when the wind turbines aren’t turning.

This is not a question of if, but when, since no more coal-fired generators are going to be built, and the system is on the way to being 100% renewable, mainly solar.

The two ways this problem will be dealt with are demand response and arbitrage.

Demand response is where AEMO pays businesses to shift their power usage and/or turn off machines at certain times. It’s mostly organised by big aggregators, such as the Italian company, Enel X, which aggregates about 8 gigawatts of power around the world from a few thousand customers. Its average margin (clip) is 30%, but it ranges from 10% to 50%.

“Arbitrage” refers to the price difference that is now opening up between the day and night, as solar drives the daytime price down and retiring coal generators drive up the night-time price.

It means there is big money to be made buying solar during the day, storing it and selling it into the NEM at night, and this should encourage a lot of businesses to build storage of some sort to take advantage of it.

In the light of that, you might want to have a look at this week’s interview with Simon Kidston of Genex Power, which is building a pumped hydro storage facility in north Queensland.

The Climate Change Tipping Point

The other potential tipping point, which I didn’t talk about in my speech this week, concerns global warming, and insurance.

The argument over whether climate change is real or not, and more specifically that it became a left/right issue, so that half the community felt obliged to say it wasn’t real because the other half was saying it was, has lulled everyone into a false sense of security.

The thing that is likely to change that complacency, it seems to me, is insurance.

In May the world’s largest reinsurance firm, Munich Re, said: “If the risk from wildfires, flooding, storms or hail is increasing then the only sustainable option we have is to adjust our risk prices accordingly. In the long run it might become a social issue. Affordability is so critical [because] some people on low and average incomes in some regions will no longer be able to buy insurance.”

Last year, IAG said if global temperatures rose by 4 degrees, the world would become “pretty much uninsurable”. It said Queensland would be virtually uninsurable in a 3-degree world.

The Paris target is no more than 2 degrees, but with the US out of that deal, the Australian Government fudging it, and other countries just ignoring it, that looks challenging.

But in any case, even 2 degrees of warming is going to make large parts of the world uninsurable.

I’m reminded of that every time I look at the app on my phone that shows the numbers planes in the air – it’s incredible the amount of flying that everyone is doing these days. It’s all very well for the electricity grid to go 100% renewable, as discussed above, and for everyone to start buying electric cars, but it will be a long time before aircraft are electric, or ships at sea, or even heavy trucks for that matter.

Most transport will remain fossil fuel based, as will a lot of electricity in developing countries. Emissions from road passenger transport will collapse, but not air travel or freight.

And then there’s livestock: the world is not going to go vegan in a hurry.

As with the coming collapse of coal generation, the rise in the cost of insurance is likely to happen with a rush at some point. Reinsurers will suddenly realise that with bond yields where they are, and claims picking up, they have to protect their capital.

It’s at that point – when the reinsurers wake up – that the impact of climate change on investment portfolios will be felt, not when further into the future when global warming actually takes effect.

The only thing we don’t know is when that will happen.

Research and Diversions

Research

Me and Mr Smith:

People love fighting over Adam Smith, but “The extraordinary breadth and sophistication of Smith’s thought reminds us that economic thinking cannot – and should not – be separated from moral and political decisions.” 

Here’s a firmly-held alternative view to mine: why you should not underestimate the severity of the coming recession. “My view … is that virtually everyone is underestimating the tremendous economic risks that have built up globally during the past decade of extremely stimulative monetary policies.”

A good rundown from the IMF on the impact of US-China trade tensions, including this chart:

Interesting proposition: everything is securities fraud. contributing to global, sexual harassment by executives, customer data breaches, mistreating killer whales, and whatever else you’ve got. All can be treated as securities fraud, which is easier to prosecute than anything else.

Roger Montgomery: What do A2 Milk and Nine Entertainment have in common? They represent two key themes that Australian investors should focus on. These themes are: businesses with global growth opportunities, and those exposed to the booming demand for software and data.

What happened to Boeing. The old Boeing was “less a business than an association of engineers devoted to building amazing flying machines.” But in 1997, under encouragement from the Clinton administration’s military-industrial policy, Boeing took over McDonnell Douglas, and was taken over by it. The civilian division was infected by corrupt military procurement practices, wishful thinking projections,” and Senate-pleasing geographic distribution. All this led, inexorably, to the 737 Max.

What’s the difference between universal basic income and guaranteed basic income? The first is nonsense.

Artificial intelligence will change our lives. We just don’t know how.

Well, one way might in very convincing deception. “AI deepfakes are now as simple as typing whatever you want your subject to say”.

Oh, and robots will transform fast food, which may not be a bad thing. There’s a robot that can flip 150 burgers an hour, but humans simply don’t like standing over a hot greasy grill.

And it’s causing a lot of global warming: A startling new paper reveals the massive carbon footprint of machine learning.

This bloke spent 23 years arguing against climate change in a right-wing think tank. Now he’s changed his mind: “If we think about climate risks in the same fashion we think about risks in other contexts, we should most certainly hedge—and hedge aggressively—by removing fossil fuels from the economy as quickly as possible. Let me explain.”

A fascinating read about the problems of the ALP, by a Labor insider. “Labor’s Culture Wars”. “Sixty seven percent of Australians did not vote for the Australian Labor Party in the House of Representatives. Seventy one percent of Australians did not for the Australian Labor Party in the Senate. These are stark statistics for a political party that was once able to secure close to half of all eligible voters at any given federal election.”

Interesting demographic comparison of Australia and Japan.

“Our economic model looks broken, but trying to fix it could be a disaster”.

The US could easily lose the technology conflict with China. It will definitely do so if it misreads the lessons of the conflict with the Soviet Union. “In 1962, at the height of the Cold War, the U.S. sought to rally its allies to block construction of a Soviet oil pipeline that would supply Red Army forces in Eastern Europe. It was an exercise in futility.”

More people are retiring with high mortgage debts. The implications are huge.

The economics of migration – a useful primer on why most economists favour more migration. “The main beneficiaries of immigration are likely to be the immigrants. They are taking advantage of the opportunity to move, believing that they will be better off, and by a sufficient amount to justify the costs”. 

Diversions

This some story about Boris Johnson. Read it.

Scientists have engineered a smooth, beanless coffee. They won't reveal exactly what it’s is made of, but the company says it is a mixture of dozens of compounds found in food, such as antioxidants, flavonoids and coffee acids. It’s probably horrible.

I’m a bit of a fan of Paloma Faith. This is a very interesting (audio) interview with her.

My sport is billiards – I play a couple of times a week. Here’s something to aim at – a break of 335. Incredible.

The imagination is the subject of Felipe Fernández-Armesto’s latest grand sweep of a book. Not a historian to dwell on individual kings, queens or battles, he has identified the creation of ideas as the driver of history, the imagination as their source and the pool of evidence the past 800,000 years.

Don’t scorn Boris Johnson’s ambition. He is reported to have broached the possibility of the Channel Tunnel being supplemented by a bridge during a Franco-British summit last year, only to be slapped down by the famously unimaginative Theresa May. Yet a bridge providing a road link was part of the original Channel Tunnel discussion. It is technically feasible; it would … send a forceful message about how the UK might be “leaving the EU, but not leaving Europe”, as the politicians like to say. 

This is great! “Garlic, pineapple, pomegranates: the definitive guide to peeling 11 of the trickiest foods”.

This Uber article is brutal. "Uber's most important innovation has been to produce staggering levels of private wealth without creating any sustainable benefits for consumers, workers, the cities they serve, or anyone else"

Well this good news: Past research has linked coffee to a host of negative health outcomes. Now, thanks to refined methodology, scientists say the exact opposite may be true.

The Catholic Church should abolish the priesthood. “Clericalism, with its cult of secrecy, its theological misogyny, its sexual repressiveness, and its hierarchical power based on threats of a doom-laden afterlife, is at the root of Roman Catholic dysfunction. Clericalism is both the underlying cause and the ongoing enabler of the present Catholic catastrophe.”

What people actually die from, compared with Google searches on the subject of death, and what the media thinks – or rather says – what’s going on.

Happy birthday (yesterday) Carl Off, the late German composer, most famous for Oh Fortuna, from his cantata Carmina Burana, one of the great choral works of all time. Certainly one of the loudest anyway.

Ask Alan

With Alan at the Energy Efficiency Council conference, #AskAlan will be back next week!

Don't forget the weekly Facebook #AskAlan livestream has migrated to a new platform on the InvestSMART website which can be found here. And if you would like to #AskAlan a question, please email it to askalan@investsmart.com.au.

Next Week

By Craig James, Chief Economist, CommSec

Australia: Jobs data dominates

• In the coming week there is little in the way of top-tier economic data. But the all-important June employment report will hog the headlines towards the end of the week. Before this, the minutes of the Reserve Bank’s July 2 Board meeting - where interest rates were cut for a second successive month - are issued on Tuesday.
• The week kicks off on Tuesday when the weekly series of consumer confidence will be released from Roy Morgan and ANZ. Consumers have been given a ‘shot in the arm’ by income tax and mortgage rate cuts, boosting their potential purchasing power.
• Also on Tuesday, the Reserve Bank Board’s July 2 monetary policy meeting minutes will be closely observed. At that meeting the cash rate was cut by 25 basis points to a record low 1 per cent. It was the first back-to-back rate cut since mid-2012.
• But Reserve Bank Governor Philip Lowe has since signalled that he may sit pat in the near term, choosing to “closely monitor how things evolve over the coming months”. While developments in the labour market remain the Bank’s key focus, the June quarter update on inflation looms large at month-end.
• On Wednesday, Westpac and the Melbourne Institute releases the Leading Index for June. The May reading of -0.1 per cent implies a continuation of sub-trend economic growth into the second half of 2019.
• On Thursday the NAB releases the June quarter survey of business confidence and conditions.
• Also on Thursday, the employment report for June is issued. Both the unemployment and underemployment rates have ticked up in recent months. And leading indicators of jobs growth have weakened. The participation rate has hit record highs.
• The Reserve Bank has cited spare capacity in the labour market for successive quarter per cent rate cuts in June and July. Commonwealth Bank economists have forecast 5,000 jobs to have been created in June with the unemployment rate stuck at 5.2 per cent for a third consecutive month – above the Reserve Bank’s 4.5 per cent “full employment” target.

Overseas: China economic growth data in focus

• Chinese economic growth and activity data are amongst the highlights in the coming week. In the US, retail spending and the Federal Reserve’s Beige Book will be keenly observed ahead of the next interest rate decision.
• The week begins on Monday in China with economic growth data for the June quarter. The economy grew at a 6.4 per cent annual pace in the December quarter, the slowest growth rate since March 2009. And growth is expected to slow even further to around 6.3 per cent after the hike in US tariffs on US$200 billion worth of Chinese goods and services in May weighed heavily on China’s factories and the export sector. 
• In addition, Chinese retail sales is tipped to have grown at an 8.5 per cent annual pace in June with production up 5.3 per cent and investment up 5.6 per cent. Home prices are tipped to grow by around 11 per cent over the year.
• On Monday in the US, the influential New York Federal Reserve Empire State Manufacturing Index is issued.
• On Tuesday, the regular weekly reading on US chain store sales is due, along with retail sales, trade prices, industrial production, capacity utilisation, business inventories and homebuilder sentiment data. Retail spending is tipped to lift by 0.2 per cent - the fourth successive monthly gain - after a solid 0.5 per cent jump in May. 
• On Wednesday, the weekly mortgage applications figures from the US Mortgage Bankers Association are due. The June readings on housing starts and building permits are issued. The US Federal Reserve’s Beige Book will be scrutinised for an expected improvement in the economic outlook across districts after trade tensions between the US and China receded at the G20 Summit in Osaka, Japan. But modest growth is expected later this year.
• On Thursday, the weekly figures on new claims for US unemployment insurance are issued, along with factory data from the Philadelphia Federal Reserve. The Conference Board’s Leading Index is also issued. The index was unchanged in May – the first month without an increase since January. 
• On Friday, the University of Michigan releases its preliminary July estimate of consumer sentiment.

US earnings season

• The US profit reporting (earnings) season gets into full swing in the coming week. S&P 500 companies are expected to report a 2.5 percent fall in second quarter earnings growth according to Bloomberg data.
• Amongst companies reporting on Monday: Charles Schwab, iHealthcare, JB Hunt Transport, QBioMed.
• Tuesday: BlackRock, Domino’s Pizza, Goldman Sachs, Johnson & Johnson, JPMorgan Chase, Morgan Stanley, Netflix, United Airlines, UnitedHealth, Wells Fargo.
• Wednesday: Alcoa, Bank of America, IBM, Kaiser Aluminium, Steel Dynamics, Texas Instruments, United Rentals.
• Thursday: AMEX, Bank of New York Mellon, Microsoft, PayPal, Philip Morris, Skyworks Solutions, Snap-on, Travelers.
• Friday: Cleveland-Cliffs, E*Trade, eBay, Honeywell, Schlumberger, State Street.

Last Week

By Diana Mousina, Senior Economist, AMP Capital

Investment markets and key developments over the past week

• Global share markets were mixed this week. Dovish comments from US Fed Chair Powell confirmed market expectations for rate cuts starting from July boosting US equities but these expectations were tempered by stronger US consumer price data. This week, US shares are up by 0.3% (and hit a record high), European shares are 0.9% lower, Japanese shares fell by 0.5%, Chinese equities are 2.8% lower and Australian shares are down by 0.7% (but this follows significant outperformance over recent weeks). US 10-year yields lifted noticeably, to just over 2.1% and the US dollar fell.
• Oil prices rose on continued tensions in the Middle East and concerns of supply cuts as data showed a decline in oil stocks.
• No major updates on US/China trade relations although President Trump did tweet that China needs to be buying more US agricultural products (to reduce the US trade deficit), as previously agreed by the two nations. The US relaxed restrictions this week on US companies selling to Chinese telecommunications companies Huawei but this is not a sign that trade dispute risks are diminishing, negotiations are likely to continue for months.
• Trade issues flared up between Japan and South Korea as Japan imposed restrictions on materials exported to South Korea, which Korean firms use for various tech products like smartphone chips. This trade spat reflects historical tensions and is unlikely to go much further but is another negative for the global economy, at a time when growth is already under pressure.

Major global economic events and implications

• Global central bank easing remains a key theme in markets. US Fed Chair Powell gave his semi-annual testimony to Congress and reinforced expectations for a July interest rate cut with commentary that the Fed has turned more dovish since its June meeting because of “uncertainties around trade tensions and concerns about the strength of the global economy” and concerns that low inflation will persist for longer than expected. Following the testimony, data for US core CPI (excluding food and energy) for June rose a little more than expected, by 0.3%, with annual growth increasing to 2.1%. While this was above expectations, inflation is hardly out of control so another two or three 0.25% interest rate cuts should still be expected this year, with the first in July. Markets are still pricing in another three cuts over the next six months. US Fed minutes from June indicated that many members agreed that more policy stimulus was necessary, and that inflation would take longer than expected to get back to the Fed’s target.
• Chinese price data this week showed no growth in producer prices over the year to June which was lower than expected and led to concerns about deflation. Consumer prices rose by 2.7% over the year to June (as expected) as a spike in food prices is keeping consumer price growth elevated.
• The Bank of Canada (BoC) kept interest rates unchanged at 1.75% but the statement around its decision appeared to be a little more dovish, noting the downside risks to the outlook (mainly from trade tensions). With the other major central banks currently easing monetary policy, or getting ready to ease, the BoC might follow the same path as the year progresses.

Australian economic events and implications

• The June NAB business survey was disappointing, with business confidence down in June (but still positive) after the post-election bounce in the prior month which shows that the fundamentals for businesses are still soft. The employment sub-index increased in June, but the index has still been trending lower over the past few months. On employment indicators, the ANZ job advertisements bounced up by 4.6% in June of but this followed a large fall in the prior month and the average trend over recent months has been a downtrend in job advertisements.
• Australian housing finance fell further in May, with the value of lending (excluding refinancing) to owner-occupiers down by 2.7% and investor lending down by 1.7% (see chart below). Some further downside to home lending is likely to continue for another few months but is likely to stabilise towards the end of the year as interest rate cuts lift owner-occupier and investor demand. However, we do not expect another boom in home prices or lending despite lower interest rates because of a few factors: supply of new homes is much higher than in recent years, lending standards are still tight (compared to history), foreign demand has fallen and there are still affordability issues, especially on the east coast of Australia.

Source: ABS, AMP Capital

• According to the Housing Industry Association (HIA), housing affordability is at its best since 1999 but this is not a fair reflection of the housing market. The HIA affordability index is largely a measure of home loan serviceability. The two RBA interest rate cuts this year have taken variable mortgage rates to their lowest level since the early 1950’s which is good for mortgage repayments (see chart below).

Source: RBA, AMP Capital

• But affordability is still an issue given high valuations for homes (especially in Sydney and Melbourne) despite the falls in prices over the past two years. Affordability pressures are better observed in indicators like household debt to income ratios (see chart below) which show record high debt levels in Australia (compared to average incomes), especially versus other comparable countries.

Source: RBA, Bloomberg, AMP Capital

What to watch over the next week?

• US June quarter earnings season should show okay earnings growth despite concern about weakening economic conditions and some companies revising down guidance on earnings (although this is probably a way of managing expectations!). Earnings should be up 3% over the year to June. US Fed Chair Powell speaks on “Aspects of Monetary Policy in the Post-Crisis Era” at the G7 meeting in France. US data includes the Fed Beige Book, US June retail sales, industrial production and some housing indicators like the July housing market index and June housing starts and July consumer confidence from University of Michigan.
• Chinese June quarter GDP is expected to show a slowing in annual growth to 6.2%, from 6.4% in the prior quarter. And the usual monthly activity data for June is also out, like retail sales, industrial production and fixed asset investment which may disappoint given the weakening monthly manufacturing PMI’s and poor activity data which will put pressure on Chinese policy makers to do more easing in the second half of the year.
• New Zealand second quarter consumer price data is expected to show an increase in prices of 1.7% over the year to June. A small depreciation in the New Zealand dollar show lift tradeable inflation.
• In Australia, June employment data is key. Employment growth is holding up in Australia thanks to high population growth and labour force participation, but the unemployment rate has trended upwards over recent months, to 5.2%. The RBA want to see the unemployment rate below 5%. We expect employment growth to slow over the next few months and the June employment data should show the unemployment rate remain unchanged at 5.2%. RBA Board minutes for the June meeting are likely to show an upbeat view on growth but confirm that the central bank has still left the door open to further easing.

Outlook for markets

• Share markets remain vulnerable to short term volatility and weakness on the back of uncertainty about trade, Middle East tensions and mixed economic data. But valuations are okay – particularly against low bond yields, global growth indicators are expected to improve into the second half if the trade issue is resolved and monetary and fiscal policy is likely to become more supportive all of which should support decent gains for share markets over the next 6-12 months.
• Low yields are likely to see low returns from bonds, but government bonds remain excellent portfolio diversifiers.
• Unlisted commercial property and infrastructure are likely to see reasonable returns. Although retail property is weak, lower bond yields will help underpin unlisted asset valuations.
• National average capital city house prices remain under pressure from tight credit, record supply and reduced foreign demand. However, the combination of rate cuts, support for first home buyers via the First Home Loan Deposit Scheme, the removal of the 7% mortgage rate test and the removal of the threat to negative gearing and the capital gains tax discount point to house prices bottoming out by year end. Next year is likely to see broadly flat prices as rising unemployment acts as a constraint.
• Cash and bank deposits are likely to provide poor returns as the RBA cuts the official cash rate to 0.5% by early next year.
• The $A is likely to fall further to around $US0.65 this year as the RBA moves to cut rates by more than the Fed does. Excessive $A short positions, high iron ore prices and Fed easing will help provide some support though with occasional bounces and will likely prevent an $A crash.