Summing up The Correction, Telstra, CSL, Beats and Misses, Barnaby, our app is coming, and more

Last Night's Markets
TCI News
Summing up The Correction
Telstra
CSL
Beats and Misses
Barnaby, Oh Barnaby
The Singularity
Research and Diversions
Facebook Live
Next Week
Last Week

Last Night's Markets

TCI News

I’m delighted to report that our mobile app is finally in with Apple and Google (Android) for approval. It should be in both the App Store and Google Play Store in a week or two.

This has been a long and painful process (I commissioned it more than a year ago) but should be worth it. The app will make it much easier to listen to our interviews and read the content on smartphones; it will still be subscriber-only, of course, but you’ll only have to log in once unless you decide to close it down completely.

And don’t forget our two events coming up over the next few weeks:

1. The ‘Tiger’s Lair’ Facebook Livestream (in our Facebook private group) on Monday at 1pm, in which you can grill a start-up entrepreneur trying to raise capital and decide whether you want to “be in” or not, as they say on Shark Tank and Dragons' Den; 2. The Constant Investor Live at 6:30pm March 13th at QPO in Kew, Melbourne, moderated by Tom Elliott with me, Nick Griffin of Munro Partners and Melinda Cilento of CEDA on the panel. Should be a fun night.

Summing up The Correction

In preview, I think we are still more likely to be in potential “melt-up” territory with the sharemarket than meltdown, as I thought at the start of the year.

So far it was no more than a useful but fairly gentle reminder that the sharemarket can be volatile sometimes – the sort of correction that happened in 1998 (20%!) and 1999 (10%), before the market took off on its journey to the March 2000 summit.

In fact it was much milder than those. On Friday, February 2nd, the ASX 200 closed at 6121 and then on the following Tuesday closed at 5833 – a fall of 4.7% over two days. That was it. As I write this here yesterday morning, it’s at 5909, a net correction over two weeks of 3.46%.

Yesterday’s close was 5904, basically flat on the day after a strong opening.

The US S&P 500 fell 8.5% and is down just 3.2% having gone up more than 1.2% in each of four of the last five sessions. What’s more the CAPE or Shiller long term PE valuation is still higher than it’s been in all but a few of the past hundred years (1929 and 1998-2000):

This was the 96th correction since the inception of the S&P 500 in 1923 and the fourth during this nine-year bull market, and it was triggered by a small rise in US wage inflation on February 2nd which lifted the 10-year bond yield above 2.8%.

In other words, this was merely an excuse for the market to do what it craved – to correct – which was shown this week when a small rise in US CPI inflation took the 10-year bond yield above 2.9%, and the sharemarket went up!

Even the VIX volatility index, which leapt from 10 to 36 in early February is back to around 20 and the “volatility sellers” are making money again.

And “bullish sentiment,” as measured by Market Vane, has only dipped from 72% to 64% as a result of the correction. Dave Rosenberg of Gluskin Sheff says we have never seen a correction run its course with Market Vane above 50%. There are still slightly more bulls (37%) than bears (35%).

Two things need to be said: first, it was not a big correction (assuming it is over now) and it attracted so much dire press commentary because there hadn’t been one for so long. Second, the fundamental issues that led to it, and have been filling broker notes for two weeks, are still with us.

Both equities and bonds in the US are still very expensive (less so here, but still not cheap); a strong synchronised global recovery is underway that should result in some decent monetary policy tightenings this year; global debt levels are still very high – globally, 318% of gross GDP compared with 280% at the end of 2007 when the GFC began; and Donald Trump is still in charge of the United States, which means anything could happen, including nuclear war.

But I don’t think it was a fundamentally-driven correction – it was about liquidity, in two ways.

Overall financial system liquidity is now declining, after nine years of a Fed flood, for the simple reason that QE has ended and the Fed is now withdrawing cash from the global ATM, not depositing.

And second, this cycle has something very different going on, that nobody – and I mean absolutely nobody - really understands: the growth of investing with machines and indexes.

This sort of technical trading, in which no attention whatsoever is paid to the businesses whose shares are being traded, and it’s all about arbitrage and relative performance, has always existed. But it’s been at the margins.

Now arbitrage and relative performance is at the forefront; machines and index trading dominate the market and fundamentals-based investing is at the margin. Active fund managers have been losing market share and broking analysts have been losing relevance, and pretty soon analysts will be almost entirely irrelevant because new rules means that fund managers will have to pay for their work rather than bury the cost in transaction fees paid by clients.

It’s likely that the machine traders and passive index investors are largely responsible for the decline in volatility over the past few years, and their dominance now doesn’t necessarily mean higher volatility in future.

Fundamentally, the US market is fairly expensive – about as expensive as it was 1998 – and the Australian market is right on the long-term average. Economic growth is happening everywhere and earnings are rising. Interest rates are rising. Liquidity is tightening. Human investors are bullish, but most of the trading is done by machines or humans who don’t care one way or another.

It is, in short, a time to invest for earnings growth with yield as a secondary outcome, rather than the other way around.

Most income investors have been looking for fully-franked yield and hoping that earnings don’t fall, and when interest rates were falling that was a winning strategy because valuations were rising.

You could get 5% yield plus 5% capital growth without any increase in earnings at all.

That will no longer work. Valuations will now come under pressure as interest rates fall, so that if earnings don’t grow, what you make in yield will be lost in capital shrinkage. The best income stocks now are those that can grow earnings as well.

Telstra

An example of the above is Telstra. In this week’s results the interim dividend was cut from 14c to 11c (including a 3.5c “special dividend” whatever the hell that means) and earnings per share was 14.3c.

Even if the final dividend is also 11c, making a total of 22c, that makes the yield 6.4%, fully franked, at today’s price of $3.45, which is not shabby at all.

But those earnings are going nowhere for years. Earnings per share this year is likely to hit 21c and it will still probably be 21c in two years’ time. That means a PE ratio of 16.5 – OK for a stock that’s growing earnings, but not one that’s facing problems. Much the same goes for the banks.

You’re better off accepting a lower yield, say IAG’s 4.1%, with the prospect of earnings growth.

(Although I hasten to add that you shouldn’t sell Telstra or the banks if you’re sitting on big capital gains and would crystallise a tax event – just don’t buy any more.)

CSL

And an even better example, this time of the opposite, is CSL. I think we can declare this to be still Australia’s premier company: at $69 billion market, it’s the sixth biggest on the ASX, but I think it’s easily the best of the large caps. A true national champion.

Everyone thought CSL’s growth rate would be crimped after Brian Macnamee retired in 2013. He was regarded as Australia’s best CEO and the stock had produced capital growth of 24% per annum for the 20 years he ran the company. Surely that couldn’t continue without him.

But since Paul Perrault took over, the capital growth has stayed at 24% pa, and it is now exactly 200 times the original float price of 76.7c. The dividend yield is a relatively modest 1.6%, but with share price growth 24%, you can always sell some shares for more income.

Here’s a summary of what the analysts said about CSL’s results this week, and it is plaudits all round:

Citi:

• Upgrade FY18-20 EPS by 1-5%
• Target price increases to $175 (from $165)
• We expect Seqirus to be profitable in FY18
• More expenses coming in 2H but FY18 guidance still looks conservative

CLSA:

• Volume growth continues to surprise
• CSL’s guidance looks conservative in our view
• We are ahead of guidance for a number of reasons including
• Potential for margin uplift in Behring 
• FY18 Seqirus EBIT will be ahead of guidance (we forecast EBITDA of $83m)
• EPS forecasts increased by 4.2% in FY18 and 3.9% in FY19
• Target price increased 3% to $164.75 (from $160)

Credit Suisse:

• We have upgraded EPS by 3.7% in FY18
• Target price increases to $160 (from $155)
• We view the guidance for Seqirus as conservative and forecast FY18 EBIT of $33m
• We believe market share gains in Behring will be maintained in the short-to-medium term although we note the heavy capex required

Evans & Partners:

• Seqirus was the standout performer, turnaround seems ahead of schedule, flat EBIT in FY18 appears unfeasible
• Growth into FY19 is becoming the focus which we expect will continue to be supported across a range of products
• We suspect a degree of conservatism to FY18 guidance, there is a risk CSL will need to upgrade again by the end of FY18

JP Morgan:

• We are confident CSL will report FY18 ahead of guidance thanks to a maiden profit from Seqirus and continued momentum in plasma
• We believe this will be achieved despite a lift in costs which appear partially driven by management as it seeks to take advantage of another stronger than expected first half.
• We have raised our target price to $166 (from $161)

Macquarie:

• Revised FY18 guidance appears conservative
• EPS upgrades of ~3.5% in FY18/19
• Target price raised to $165 (from $154)

Morgan Stanley:

• FY18 guidance appears conservative
• Seqirus to do better than breakeven, we estimate $60m upside risk
• 1H17 atypical market conditions not an obvious tough comp, Ig growth at 7% was solid
• Price target raised to $142 (from $132)

UBS:

• Another high quality result
• We see upgraded FY18 guidance as conservative
• Our DCF price target lifts in line with EPS upgrades to $155 (from $147)
• Stock now trades at ~33x FY18 PE, we maintain a neutral rating on valuation grounds

Beats and Misses

As for the rest, week one of the reporting seas saw eight companies beat expectations (RMD, TWE, JHG, AGL, IEL, MGC, NWS, MIN) and six companies miss (CBA, AMP, TAH, NVT, AQG, RIO).

There were more positive dividend surprises than negatives at 4 (MFG, CIM, IEL, MIN) vs 3 (TAH, GMA, RIO) and most companies have had expected earnings revised for FY18, with downgrades (11) outnumbering upgrades (8). Significant downgrades have come from GMA, AQG, AMP, MIN, TAH and CBA.

Aggregate growth expectations for FY18 have fallen from 8.4% to 6.8%, driven by downgrades to the banks, which is mostly about CBA including one-off charges in the cash earnings line.

Small caps have seen smaller downgrades so far than mid to large caps, but that’ll change – the small companies tend to hold back the bad news and generally report late.

Growth expectations for FY19 have risen since the beginning of reporting season (from 4.5% to 5.3%), with the largest changes to EPS growth coming  from small cap resources and the banks. There continues to be a lot of optimism built into the next financial year for the industrials (ex-resources, LPTs and banks), with estimates ( 13% EPS growth) still rising strongly, unlike at this point in previous years.

All up, so far so good from the reporting season and no sign of anything yet to get worried about.

Barnaby, Oh Barnaby

I don’t have a lot to add on this subject, except that Joyce will obviously have to stay on the backbench, at least for a year or two. All else being equal, this will be a big plus for the Government and will help Malcolm Turnbull win the next election.

But all else is not equal, of course, and they definitely won’t win if the Coalition falls apart. The Nationals now have an interesting choice: do they hunker down with Barnaby against the cursed, interfering Liberal Party, or do they cut their losses and sack him, to preserve the possibility of being in Government, with their disproportionate number of ministries?

As for Barnaby Joyce himself, Miranda Devine and others go on about what a good politician he is and an asset to Turnbull, but if he ever was, he isn’t any more. Never has been, in my view.

He was accident prone and a terrible liability well before he decided to bonk his press secretary and get her up the duff, and then try – absurdly - to hide it. His self-regard and incompetence was further confirmed by yesterday’s performance, in which he portrayed himself as the victim and further damaged the Coalition by taking a swipe at the PM.

The current debacle of water policy is his fault, since he has always refused to do anything but pander to irrigators, but more broadly he has been entirely out of touch with modern Australia, preventing the Government from coming up with sensible progressive policies on such things as marriage equality, climate change, energy policy, and foreign investment.

The Nationals under Barnaby Joyce have become a dead weight for the Libs, and the only people who think otherwise are those, like Miranda, who value conservatism above success.

In fact, Joyce and the Nationals, supported by Tony Abbott, have been responsible for most, if not all, of the Government’s failures over the past couple of years.

In a way, the decision before the National Party now is whether to modernise or not: do they stick with the traditional right-wing bush conservatism, or do they move towards a more nuanced view of the world that better reflects the views of urbanites that are now moving into their traditional seats because of very high house prices in the city?

If they don’t, and with Joyce now humiliated and probably gone entirely, their influence will be shot, and the Liberal Party will ignore them.

If he can, and with someone other than Barnaby Joyce as Deputy PM, Bill Shorten will now have a proper fight on his hands.

The Singularity

Desmond writes: I have been taking your advice on investments for many years, usually profitably. Now I find myself wondering about the world we are making for our grandchildren. My question is this: do you think that, with Facebook and Amazon and Apple and Twitter and the rest, and with the many spin-offs of blockchain technology, the Singularity is now upon us, as human beings voluntarily give up the autonomy that makes them human to become the instruments of an internet which, driven by super-rich men aiming to become super-richer, increasingly serves its own purposes.

That was a question in this week’s Facebook Livestream Q&A, which I had some trouble answering on the spot. It’s a big question and deserves a thoughtful answer, so I told Desmond I’d have a crack at it in the Overview.

Not that I claim to be a philosopher on these matters, or any others. But I have been thinking about the issue, and the Singularity was in the part-novel I wrote on long-service leave two years ago. (It’s still sitting in my laptop, staring balefully at me, waiting to be fixed up and lengthened.)

There have been various definitions of the singularity, but it’s usually described as the point when machines become smarter than us. In one way it’s already happened, since they are beating us at chess.

Ray Kurzweil, Google’s director of engineering, said recently: “2029 is the consistent date I have predicted for when an AI will pass a valid Turing test and therefore achieve human levels of intelligence. I have set the date 2045 for the ‘Singularity’ which is when we will multiply our effective intelligence a billion fold by merging with the intelligence we have created”.

That’s a pretty fancy definition, and I’m not sure what he means by “merging with the intelligence we have created” but since it was done by a bloke at Google it probably fits in with Desmond’s concern that it’s all about super-rich men becoming super-richer.

I think Desmond is definitely onto something, but in preview – I don’t agree.

The internet isn’t a thing that has a purpose – it’s simply a set of protocols that allow efficient packet-based communication to take place.

Blockchain is another set of protocols that use the internet protocols to store records on a lot of computers simultaneously, making the packets useful for transactions for the first time.

That’s an oversimplification, of course, but not much of one I think.

Anyway, I think the internet, and now blockchain, have allowed the creation of new form of capitalism to flourish. The simple, but powerful reason for this is that the clanking machinery of regulation, oversight, and most importantly, the human impulse towards to social equalisation, takes longer than the machinery of commerce – much longer.

I’ve been trying to think of historical parallels to what we are going through now, and I suspect there have been only a few. One was the rise of the railroad barons in the late 19th century, with the oil tycoons and Wall Street financiers at the same time.

At that time the flowering of railway and telegraph technology, along with the discovery of oil and the development of investment banking, produced vast fortunes – to the point where the Rothschilds, John D Rockefeller, and Andrew Carnegie are numbers 2, 3 and 4 on the list of the richest people in history (the richest was apparently Mansa Musa I, the ruler of Mali in 14th century).

Rothschild, Rockefeller and Carnegie had fortunes worth more than US$300 billion in today’s money. Today’s richest person is Jeff Bezos, who is closing in on US$100 billion.

But everything’s relative and today there are so many more rich people than there were a century ago. I haven’t seen stats on this, but I suspect that although there was greater inequality in the 19th century if you compare the richest with the poorest, there are many more very rich people today than there were then.

Then the wars and revolutions of the 20th century evened things out by imposing political controls where few had existed before.

Towards the end of the century, the pendulum swung back and deregulation and globalisation occurred, led by Reagan and Thatcher but endorsed by both sides of mainstream politics.

That coincided with the rise of technology and the internet but the dotcom crash in the first months of the new century, in March 2000, lulled everyone into thinking it wasn’t much of an issue and wouldn’t lead to the accumulation of great wealth.

And then on top of that the economics profession became the unwitting tool of rich, led by a succession of bubble merchants at the Federal Reserve. Greenspan, Bernanke and Yellen responded to the genuine economic threats with super-low interest rates that inflated asset prices – deliberately.

The idea was that high asset prices would lead to investment which would lead to jobs and prosperity for all.

The problem was that in the meantime technology and the internet had roared back to life, so that the investment has been in machinery and software, not humans.

So Desmond’s point that “human beings voluntarily give up the autonomy that makes them human to become the instruments of an internet” is valid, not that there’s some kind of metaphysical process taking place, or that it’s a takeover by machines, as in the Terminator movie series (not yet anyway!) but simply that many jobs are being given up.

The parallel with the 19th century tycoons is that they got rich by giving the masses what they wanted – fast railway transport, oil, communications etc. Henry Ford (No.9 on the list with US$200 billion) did it by giving the masses the cars they wanted.

Bezos, Gates, Zuckerberg, Page and Bryn are doing likewise. Apple is the richest company in the world because its products are fantastic, its brand impregnably desirable. The same is true of Facebook, Google and Amazon. In a way, they deserve to be rich.

The question is whether we making a kind of pact with the devil here – giving up our autonomy, as Desmond puts it, to get the pleasures of a smartphone, or Facebook, or goodies delivered to our door, and leaving a dysfunctional, or worse, world for our grandchildren.

Maybe. Perhaps the Singularity is when we become mere instruments of the internet.

But I don’t think so. The world is obviously getting better all the time.

Just a small mundane example: Deb and I watch Bondi Vet all the time on TV, because we are animal lovers. The lengths to which pet-owners and the vets now go to save animals with expensive operations is astonishing. I know this through personal experience as well.

Yet only a couple of decades ago, pets were put down at the drop of a hat. “Put them out of their misery,” was the refrain. Now their misery is relieved through sophisticated medicine, not death.

I think this is wonderful, a measure of our humanity. So is the #metoo movement that is shifting the balance of power between men and women and calling men to account for bad behaviour.

To be honest, I’m not too sure about the advent of interchangeable gender – men suddenly deciding they are women and becoming so by simply saying they are - but that’s just me. I’ll probably get used to it eventually, with the help of my (insistent) kids, and I certainly have no problem with same sex marriage.

It’s not just in the alleviation of poverty that I think things are getting better, but in the development and expansion of our humanity. And what’s more I think that the internet has helped that by allowing instant global communication: everyone can now see what everyone else is doing, and can get organised to demand change.

So, Desmond, I can see where you are coming from, but I don’t think we need to worry. There have always been super rich people, and always will be. They used to be super-richer than they are today, in fact.

And as for the coming Singularity: I suspect, but don’t know, that it will be a bit like the “millennium bug” that was going to cause chaos at midnight on December 31st, 1999. It didn’t.

Research and Diversions

Research

This is the ultimate resource on blockchain and cryptocurrencies- a long list of very good links on those subjects.

Michael Lewis reports on watching Trump, and ends up watching the State of the Union speech with Steve Bannon: “What Bannon thinks, I'm guessing, is that Trump does not understand how he got elected. He doesn’t understand the power of the anger he’s tapped, almost by accident. And he likely never will.”

Donald Trump cheats at golf? As revelations about the forty-fifth US president go, this hardly lands as a shock.

The myth of John Kelly and other “adults in the room” in Trump’s White House is unravelling.

Sarah Huckabee Sanders Repeatedly insists that the President’s footprints created the Great Lakes (The Onion).

Here’s a useful timeline of the Barnaby Joyce disaster.

Three new recently published scientific papers seem to confirm what many have claimed for years: the "efficient markets" are not only inefficient, they are also rigged. 

Short sellers are the market’s detectives.

Micro-plastics are polluting the most remote parts of the ocean.

Can Australian home-owners withstand higher interest rates. Yes. Probably.

What is driving populism? It is not the economy - about 20 years of social science research is now pointing to (non-economic) identity angst.

True wealth is not money. And no, it’s not happiness etc: it’s the option to buy what you truly need. If money can’t buy what you need, you’re on even footing with the poorest person out there. Wealth is living in a society where you have the option of spending money on the things you need.

This guy, a mathematician named Gil Kalai, says quantum computing can’t possibly work. “He has analysed the issue by looking at computational complexity and, critically, the issue of noise. All physical systems are noisy, he argues, and qubits kept in highly sensitive ‘superpositions’ will inevitably be corrupted by any interaction with the outside world.” 

Machines working with people will always be smarter than machines or people working alone. Machines bring logic to the table, humans bring intuition.

A conversation with Matt Levine, lawyer, investment banker, writer. Topics include derivatives, clearing houses, cryptocurrencies, Uber, ICO frauds, volatility, IPOs, M&A, indexing, bank regulation, efficient markets, Horace, Catullus, Buffy, law, Park Slope, Virgil, Pnin.

Is Brexit the maddest thing England has ever done? Not quite. In its very long history – much longer than most political entities can claim – there is just one episode that is more thoroughly unhinged. 

This is huge: As part of Mifid II, a new regulation in Europe, sell-side research can no longer be bundled into trading commissions, and is to be paid for separately. Any provision of unspecified or free research to asset managers and institutional investors is treated as an "inducement", and is banned.

While concerns about illiberalism, populism, and majoritarianism are certainly well-founded, blaming such phenomena on an “excess” of democracy is not. Such arguments rest on a fundamental misunderstanding of how liberal democracy has historically developed and how liberalism and democracy actually interact.

Diary of an IPO. Day One: A Rolling Panic Room. The roadshows … are choreographed pandemonium, starting on a Monday in New York City, and ending nearly two weeks later back in the same place with an IPO. In between, there are ten meetings a day, in a new city, every day.

Post work: the radical of a world without jobs. “Life with much less work, or no work at all, would be calmer, more equal, more communal, more pleasurable, more thoughtful, more politically engaged, more fulfilled – in short, that much of human experience would be transformed.”

Why automation is different this time. Reason number one: The economy has three broad sectors: agriculture, manufacturing, and services. The first wave was in agriculture, and people could switch to manufacturing. The second wave was in manufacturing, and people could switch to services. The current wave is affecting services, but there is no fourth sector of the economy left to switch to.

Robert Skildelsky: Unlike the Great Depression of the 1930s, which produced Keynesian economics, and the stagflation of the 1970s, which gave rise to Milton Friedman's monetarism, the Great Recession has elicited no such response from the economics profession. Why?

Mohamed El-Erian: the recent turmoil could restore some normality to markets.

Gross domestic product was devised as a shorthand way of measuring the American economy in the 1930s; but it is not much good at measuring modern economies; and it is downright misleading as a basis for government policy. GDP measures quantity and price. It does not measure the virtue, or value, or social utility of economic activity. Producing 2.5 billion disposable coffee cups a year is good for GDP, even though future generations will be fishing them out of the ocean for centuries.

Why Jerome Powell won’t abandon the ‘Greenspan Put.’

A simple process can make wood stronger than steel. Besides taking a star turn in buildings and vehicles, the substance could even be used to make bullet-resistant armour plates.

Diversions

Deb and I went to see Colin Hay at the Melbourne Recital Centre the other night (and saw my friend Doug Turek and his family there too, by the way). It was a lovely concert – he’s so good. This video obviously isn’t a track from that concert, although he did play this song of course – but it’s great! It’s “Overkill”, with a choir as the audience, singing with him.

Martin Amis on the genius of Jane Austen (and what the adaptations get wrong).

A very good introduction to the ideas of John Stuart Mill, the founder of liberalism, who argued that there should be “no interference with the thought, speech, or action of any individual except on the grounds of the prevention of harm to others.”

Fantastic new pictures of Jupiter from NASA’s new $1b probe.

Smart TVs are vulnerable to being hacked. Someone, somewhere else, could change channels on you! Turn up the volume! Turn it to (gasp) The Bachelor!

How Paul McCartney became a bassist: “We were in Hamburg and Stu had fallen in love with this girl Astrid. Eventually he said, Well, I’m gonna stay here with Astrid. So it was like oh-oh, we haven’t got a bass player. And everyone sort of turned round and looked at me. I was a bit lumbered with it, really.”

The Old Testament isn't funny. But Jews produce so much humour. Why? Theories abound, few of them funny.

The lost art of growing old, with intention.

The Dunedin Study findings are that diabetes, heart disease and infant mortality are all greater in number among children raised in poverty. Why? Because children growing up in poverty are subject to stresses which, over time, create inflammation in their blood.

Why are the Amish so fertile? Their population doubles every 15-30 years - not having phones helps.

Check out this version of REMs “Everybody Hurts”, by The Corrs.

Peter Gabriel turned 68 on Tuesday. Imagine how many times he has sung Solsbury Hill… Here he is doing it on Letterman in 2011, with full orchestra! And he does look pretty bored with it.

It’s not Lou Reed’s birthday till next month (he turns 72), but what the hell – here he is doing Sweet Jane.

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 we've just given the Facebook Livestream its own 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 hello@theconstantinvestor.com then keep an eye out for the Facebook Live video in next week’s overview.

Next Week

By Craig James, CommSec

Australian wages growth is crucial to the inflation and interest rate outlook

• This week is all about wages growth in Australia. The December quarterly Wage Price Index is arguably the most important data released so far this year from an inflation and interest rate setting perspective. The semi-annual update on average weekly earnings will also be keenly observed.
• The week kicks-off on Monday when the Australian Bureau of Statistics (ABS) issues the Overseas Arrivals and Departures publication that includes short and longer-term tourist and immigration data. Record numbers of Chinese tourists are holidaying in Australia, boosting spending in our retail and accommodation sectors.
• On Tuesday the Reserve Bank releases the minutes of its February Board meeting. Few additional insights are expected following the release of the quarterly Statement of Monetary Policy on February 9. The Bank’s growth and inflation forecasts were left unchanged which means interest rates are on hold for some time.
• Also on Tuesday the weekly ANZ-Roy Morgan weekly consumer sentiment results are released. And the Assistant Governor (Financial System) at the Reserve Bank, Michele Bullock, is scheduled to address the Responsible Lending and Borrowing Summit in Sydney.
• On Wednesday the much-anticipated December quarter Wages Price Index is issued by the ABS. Wages growth has lifted off 20-year lows. We expect that wages rose by 0.6 per cent in the quarter, lifting annual growth from 2.0 per cent to 2.1 per cent. The labour market is tightening on strong jobs growth. Near decade-high business conditions and solid company profits are pre-conditions for pay rises. However, the Reserve Bank is only forecasting a gradual lift in wages: a “key uncertainty” for the inflation outlook.
• Also on Wednesday construction work done for the December quarter is released by the ABS. Construction work surged by 15.7 per cent in the September quarter. Roads, rail and public transport infrastructure-related spending is booming, but residential dwelling construction may have eased.
• We expect the Department of Jobs and Small Business’ Skilled Internet Job Vacancies Index to have risen for a fifteenth consecutive month in January when released on Wednesday. The index has risen to 5½-year highs as demand for skilled occupations improves across the economy.
• The average weekly earnings data is released every six months. However the figures are important as they provide dollar estimates of wages in the economy across states and industries. The figures are issued by the ABS on Thursday.

Overseas: Focus on the US Federal Reserve

• Data releases are light in a holiday-shortened week in the US. The main interest will be the minutes from the last US Federal Reserve policy meeting in January. Chinese property prices are scheduled to be released at the end of the week.
• The President’s Day public holiday is observed in the US on Monday. Financial markets are closed. 
• On Tuesday the usual weekly figures on US chain store sales – a measure of consumer spending – are released.
• On Wednesday theUS Federal Reserveissues the minutes of the January 30-31 meeting. Commentary on wages growth will be highly sought after by investors after the latest reading – the highest in over eight years – caused markets to reprice inflation expectations higher. US existing home sales have hovered near 10-month lows on record low supply. A modest increase from 5.57 to 5.6 million units is tipped in January.
• Also on Wednesday the ‘flash’ Markit February manufacturing and services purchasing managers’ indexes are released in the US, Europe and Japan.Business activity remains expansionary amid a synchronised pick-up in global growth across developed economies.
• On Thursday the Conference Board’s Leading Economic Index mat have risen for a fourth consecutive month in January. The index increased by 3.1 per cent in the second half of 2017 after rising by 2.6 per cent for the first half of the year. The underlying components of the index remain strong. The usual weekly data on claims for unemployment insurance (jobless claims) is also down on the Thursday data docket.
• Also on Thursday, US Federal Reserve voting member, Atlanta President, Raphael Bostic, gives a speech at the Banking Conference in Atlanta.
• On Saturday attention turns to China with data on property prices to be released for the month of January. The housing market picked up in December as small declines in large cities stabilised and smaller cities gained some momentum, but price growth more than halved in 2017 as government curbs on speculation took effect.

Financial markets

• The Australian corporate reporting season continues this week.
• Amongst companies to report on Monday are Brambles, SEEK, NIB, Domain, Beach Energy and oOh!Media.
• On Tuesday, earnings include those from Oil Search, Super Retail Group, Investa Office Fund and APN Outdoors.
• On Wednesday, profit results include those from Coca-Cola Amatil, Scentre Group, Santos, Wesfarmers, Lendlease, Fortescue Metals, Downer and Stockland.
• On Thursday results include: Alumina, CharterHall, Crown Resorts, Flight Centre, OceanaGold, OzMinerals, Qantas, Perpetual, Link Administration and Sirtex Medical. 
• On Friday, earnings may include Westfield, Woolworths, Accent, Automotive Holdings, MYOB and Platinum Asset Management.

Last Week

By Shane Oliver, AMP Capital

Investment markets and key developments over the past week

• Share markets rebounded over the last week as share investors became a bit more relaxed about the prospect of higher inflation and interest rates and the unwinding of short volatility trades ran its course. However, the rebound has been concentrated in the US share market (which is up 7% from its recent low) with Europe, Japan and Australia lagging. The Australian share market never fell as much on the way down but a resumption of the falling US dollar is likely playing a role in the relative outperformance of US shares as it boosts US profits and constrains profits in Europe, Japan, Australia, etc. Bond yields continued to rise over the last week, except in Japan, and commodity prices and the Australian dollar rose helped by renewed US dollar weakness and as investor confidence returned.
• While share markets have settled down to varying degrees, the strength of the US economy with fiscal policy providing an additional boost is likely to ensure that inflation will be a growing issue this year globally and we remain of view that market expectations regarding Fed rate hikes are too complacent. The next chart shows that US money market rate hike expectations are still well below what the Fed has signalled and so a further shifting up in market interest rate expectations is likely and this will drive a further rise in bond yields.

[caption id="attachment_131212" align="alignnone" width="569"] Bloomberg, AMP Capital[/caption]

• Strong earnings growth and the absence of a recession on the horizon as even US monetary policy is still easy should allow share markets to trend higher this year, but rising US inflation, interest rates and bond yields will make for ongoing bouts of volatility and a more volatile and constrained ride than we became used to last year.
• President Trump’s proposed 2019 Budget – with $US200bn in infrastructure funding over ten years (including an asset recycling plan), but a 2% cut to domestic spending - is of little relevance. Congress decides the budget not the president and at present its focussed on the deal just passed to increase spending by $300bn over the next two years. That deal already included some increase in infrastructure spending but only for two years and half what Trump is looking for. So yes, there will increased infrastructure spending in the US in the years ahead but nowhere near as much as Trump has promised. Meanwhile, Senate efforts to find a solution for Dreamers looks to have floundered for now keeping alive the prospect of another Government shutdown next month. We remain of the view that if there is one it will be short given the political damage it could cause the Democrats.

Major global economic events and implications

• Confusing US economic data – but forget stagflation worries. A stronger than expected rise in CPI inflation with January core inflation up 0.3% month on month or 1.8% year on year and running at an annualised 2.6% over the last six months and a rising trend in producer price inflation reinforces our expectations for rising US inflation this year. However, last year also saw a stronger than expected rise in inflation in January which then slowed again and some of the components that rose strongly look a bit noisy so it would be premature to get even more bearish on inflation. More importantly, the surprise fall in January retail sales looks likely to be an aberration that may owe to poor weather with strong consumer confidence, strong jobs growth, tax cuts and rising wages growth all likely to support strong retail sales going forward. Meanwhile other activity related indicators were strong. Industrial production slipped in January but small business optimism, regional manufacturing surveys and home builder conditions are all strong and their components point to strong orders and employment and rising inflationary pressures.
• Consistent with ongoing strength in the US economy, the December quarter US earnings reporting season continues to impress. Of the 388 S&P 500 companies to have reported so far 80% have beaten earnings expectations and 78% have beaten on sales. Earnings growth for the quarter is tracking up 15% year on year and revenue is up 8% yoy.
• Japanese December quarter GDP growth of just 0.1% quarter on quarter was less than expected but consumer spending was solid and leading indicators point to continued growth ahead. Bank of Japan Governor Kuroda’s nomination for another term along with comments by PM Abe and his advisers indicate that the BoJ is unlikely to ease up on its monetary policy stimulus any time soon. Particularly with the Yen rising sharply.

Australian economic events and implications

• As has long been the case in recent years Australian data was mixed. On the one hand business condition and confidence rose in January according to the NAB survey and employment rose solidly. But against this consumer confidence slipped a bit in February and the quality of the jobs report was poor with a sharp fall in full time jobs and slowing hours worked. On the jobs front, job vacancies and job ads point to continued strength but employment has overshot the strength in jobs leading indicators and so may undershoot for a while and more significantly after a good rebound in full time jobs last year we may be reverting back to lower quality part time jobs as the main driver of employment.
• For those trying to understand why the RBA is lagging behind the Fed in raising rates (apart from the fact that the Fed cut far more than the RBA did in the first place), the chart below is a good place to start. Basically, labour market underutilisation (or unemployment plus underemployment) is far higher in Australia than in the US. This means it will take longer for wages growth to pick up in Australia and for the RBA to hike rates. 

[caption id="attachment_131213" align="alignnone" width="575"] Source: ABS; AMP Capital[/caption]

• On the interest rate front, RBA Governor Lowe’s Parliamentary testimony basically repeated the Bank’s message of the last few weeks which is that the next move on rates will most likely be up, the economy is moving in the right direction, we have seen more positive economic news in recent months, but uncertainty remains around the consumer and progress in reducing unemployment and having inflation return to target is likely to be gradual. As such the RBA “does not see a strong case for a near-term adjustment of monetary policy”. We agree and don’t see a rate hike until late this year at the earliest.
• It’s still early days in the December half profit reporting season with only a third of companies having reported, but so far it remains reasonably good. 46% of results have exceeded expectations against a norm of 44%, 74% have seen profits rise from a year ago and 72% have increased dividends from a year ago. However, only about 49% have seen their share price outperform on results day and there is still a way to go yet with results often tailing off a bit as more report.

[caption id="attachment_131214" align="alignnone" width="588"] Source: AMP Capital[/caption] [caption id="attachment_131215" align="alignnone" width="595"] Source: AMP Capital[/caption]

What to watch over the next week?

• In the US, the minutes from the last Fed meeting (Wednesday) are likely to attract greater than usual attention but are likely to do little more than affirm that the Fed is on track for another hike next month. Meanwhile, expect the Markit business conditions PMIs for February to have remained solid and existing home sales to gain (also both due on Wednesday).
• Eurozone business conditions PMIs for February will also be released on Wednesday and are likely to have remained strong.
• In Japan, the manufacturing PMI for February (Wednesday) is likely to have remained strong but core inflation for January (Friday) is likely to remain around 0.3% year on year which is well below the 2% target and will prevent any imminent easing in easy money from the Bank of Japan.
• In Australia, the minutes from the RBA’s last board meeting (Tuesday) are likely to confirm that it’s a bit more upbeat but that with the move back to the mid-point of the inflation target likely to be gradual its in no hurry to raise interest rates. December quarter wage data to be released on Wednesday are likely to show wages growth of just 0.5% quarter on quarter of 2% year on year, consistent with the RBA remaining on hold for some time. Meanwhile, December quarter construction activity data (also Wednesday) will likely fall back after a strong gain in the September quarter.
• The Australian December half 2017 earnings reporting season will really ramp up in the week ahead with around 80 major companies reporting including Seek (Monday), Oil Search and BHP (Tuesday), Worley Parsons, Wesfarmers, Lend Lease and Fairfax (Wednesday), Qantas and Crown (Thursday) and Woolworths (Friday). This reporting season is expected to see a fall back to single digit earnings growth (after the resource driven surge seen in 2016-17) with overall earnings growth around 7% (compared to around 16% in the last financial year), with resources profit growth slowing to around 14% (from 130% in 2016-17) but still supported by solid commodity prices and production growth, bank earnings growing around 3% and industrials up 5% with strong results for insurers, utilities, healthcare, building materials and consumer discretionary. The main themes will be continued strength in companies exposed to housing construction and the infrastructure spending boom, the impact of the US tax cut on companies exposed to the US and the potential for some special dividends and capital returns.

Outlook for markets

• Ongoing strong economic & profit growth and still easy monetary policy should keep investment returns favourable but stirring US inflation, more aggressive Fed hikes and a possible increase in political risk are likely to constrain returns and keep volatility up after the stability of 2017 
• Share market volatility has not gone away despite the relative calm of the last week, but shares are still likely to trend higher this year as global recession is unlikely and earnings growth remains strong globally and solid in Australia. We remain of the view that the ASX 200 will reach 6300 by end 2018.
• Low yields and capital losses from rising in bond yields are likely to see low returns from bonds.
• Unlisted commercial property and infrastructure are still likely to benefit from the search for yield by investors, but it is waning, and listed variants are vulnerable to rising bond yields.
• National capital city residential property price gains are expected to slow to around zero as the air continues to come out of the Sydney and Melbourne property boom and prices fall by around 5%, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms.
• Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.
• After reaching as high as $US0.8136 which is near the top of the technical channel it’s been in since 2015, the $A is on the way back down again against the $US, and this is likely to get a push along as the gap between the Fed Funds rate and the RBA’s cash rate goes negative next month. Solid commodity prices will provide a floor for the $A though.