Telstra, Bonds, Trade War, Short Shorts, A World Cup Snippet and more

Last Night's Markets
Telstra
Speaking of bonds...
Trade War
Short Shorts
A World Cup Snippet
Next Week
Research and Diversions
Facebook Live
Next Week
Last Week

Last Night's Markets

Telstra

I’ve been negative about Telstra since I started TCI two years ago; I still am.

There’s nothing especially wrong with the plan unveiled this week, apart from the fact that it should have been done years ago and management has known that and done nothing, or not much.

It’s both astounding and telling that they can get rid of 8000 staff, cut the number of mobile plans from 1800 to 200 and sell $2 billion in assets and not only stay in business, but improve.

Without its network monopoly Telstra was always going to have to be a smaller, nimbler business that invested for growth and was totally focused on customer service.

The change in its circumstances happened on March 28, 2011, when the National Broadband Network Act was passed by the Labor-controlled Parliament, although it was known about well before that. On that day the share price opened at $2.72, which happens to be exactly where it closed on Thursday, before falling 2% or so yesterday to a record low.

Then-chair, Catherine Livingstone responded to the NBN Act by announcing a commitment to pay annual dividends of 28c a share, locking CEO David Thodey and his management team into a non-growth, cash churn strategy – basically, she turned the company’s shares into a bond.

At every investor strategy day durin the subsequent years, the CEO talked about investing for growth through innovation and about customer focus, but the brief from the board was to maintain the dividend at all costs, so investing for growth through innovation? It was just talk.

But it seemed to be not just a good idea at the time, but a brilliant one. As the 10-year government bond yield fell from 5.6% to 2.5% between 2011 and 2015, Telstra surfed the bond bull market and its share price went from $2.72 to $6.50.

Underneath, the company was decaying.

The share price surge wasn’t due to any confidence in its growth outlook post-NBN, although David Thodey tried hard to fool everybody that everything would be fine, and everybody wanted to believe that so they could keep getting the fully franked dividend, so they did believe it.

Andy Penn was appointed CEO on May 1, 2015, and immediately starting talking about a “strategic growth plan (that) was designed to transition Telstra into a global technology company”.

Oh dear. The word “global” was just too much: clunk went the share price, from $6.50 to $5.20 in November. There was then were last drinks before the train left the station, as the price climbed back to $5.80 by mid-2016, when I was launching The Constant Investor and telling subscribers to sell, and those with any brains did just that.

But then, during the Investor Day on May 2nd, 2016, Penn let on for the first time that the NBN would cost Telstra $2-3 billion a year in cash flow. It’s actually buried on page 9 of this transcript of his (very long) speech. But the cat was fully out of the bag, and that was the last time shareholders saw $5. It’s now close to half that.

The first year of the share price decline can be attributed to the bond yield going from 1.8% to nearly 3% between August 2016 and March 2017, but the long rate has flatlined since then. The collapse from $5.20 in early 2017 to now is entirely due to lower profit forecasts.

So - is the stock a buy now after this week’s song and dance, with lipstick and bright smiles?

Definitely not. Even at its existing market share, both the profit and dividend will be lower in future than they are now.

But that market share is very unlikely to be held: Telstra is a plodder in a world of sprinters, although Optus’s ridiculous mess with the World Cup streams shows that it’s not the only plodder.

The fact is (in my view) nobody is going to make much money in telecommunications for quite a while. Wrong way, go back.

Speaking of bonds...

The most important fact about global investment markets at the moment is that the US 10-year bond yield has fallen below 3% and stayed there.

It got to 3.1% in mid-May but then dropped like a stone to 2.77% by the end of the month and remains below 3% at 2.91%, despite near-universal predictions that it would move higher – towards 4% and then 5%.

Meanwhile, the US economy is ticking along nicely, you could even say it’s booming following the tax cuts, inflation is starting to rise, and the fed funds rate is rising, with the Fed itself predicting four hikes this year.

Normally you’d expect long-term rates to be climbing steadily, and producing a solid headwind for equities to offset the rising eps forecasts, but they’re doing no such thing.

As a result, sharemarkets have been on a tear: since the day the US bond yield went above 3% - Anzac Day in Australia - the S&P 500 has surged 4.4% and the ASX200 5.25%.

Part of the explanation lies in the reappearance of the euro crisis, focused around Italy following the inconclusive election that saw populists get up.

Long rates in Italy are back up at 2.7%. Nominal GDP growth is 2.4%. That means Italy is back in a debt trap because, as John Maynard Keynes noted, when the long rate on government bonds is above the nominal growth rate of the economy, debt starts compounding faster than GDP. The debt trap.

Meanwhile, German long rates are at 0.4%. If you compare the market price of a German 10-year zero coupon bond and the market price of its Italian equivalent, according to Charles Gave at GaveKal, the difference between the two implies that over the next 10 years the market is “expecting” a 20% devaluation of the Italian currency relative to the German currency.

But, as we know, in Europe that isn’t possible – Italy’s currency is effectively tied to Germany’s (the euro). So, we have a big contradiction between what market prices are telling us, and what Europe’s institutional architecture allows. And as the chart below shows, every time over the last 10 years that such a contradiction has appeared, US long rates have fallen abruptly.

This makes sense. If the euro were to break apart, the world would face a massive deflationary crisis. More than a few commercial banks in Europe would go under, and the US dollar would go up and US long rates would go down, which is what’s been happening lately in partial anticipation (the US dollar index has rallied 6.7% since mid-April).

More broadly, the markets have reverted to “risk-off”, as they have every time the euro crisis re-emerges.

But there’s something deeper going on as well, which I’ve been banging on about for a few years: the fundamental relationship between employment and inflation has broken down.

It was highlighted this week by RBA Governor Philip Lowe, sitting on a panel in beautiful Sintra in Portugal at the European Central Bank’s annual conference. His fellow panellists? Fed president Jerome Powell, ECB president Mario Draghi and Bank of Japan governor Haruhiko Kuroda (Lowe said he was the “odd man out”, coming from such a small country far away).

He was also the odd man because of his views, saying that low wages growth and low inflation would be with for “some years” because “things look different” – falling union coverage, rising labour supply because of immigration (everywhere) and rising participation and competitive pressure on companies.

"I think those factors are going to be around for a long time - I don't expect the situation we're dealing with to change quickly."

An interesting and comprehensive review of this topic appeared on the Business Insider on the same day of ECB conference, headed "The supply-and-demand model of labour markets is fundamentally broken".

It quotes a whole of international experts basically talking about how underemployment and labour market surplus is holding down wages despite the strong economy.

The author of the piece puts a lot of it down to the 'gig economy': “Pay rates no longer move upward as unemployment moves downward because companies like Uber, Just Eat, and Deliveroo can switch their demand for labour on and off on a minute-by-minute basis. Self-employed folks making a living on Etsy, Amazon, Airbnb, or eBay know their clients instantly go elsewhere if they raise their prices by even a few pennies.

“…In the old days when you lost your job you claimed unemployment benefits and lived 'on the dole'. Today, you deliver pizzas or stuff packages in an Amazon warehouse for 20 hours a week.”

So not only has a “risk-off” attitude re-emerged because of Italy’s obvious problems (even though the new Government has been saying unexpectedly sensible things) but underlying that is a fundamental shift in the way economics works.

The implications of this for investors are fantastic, as the performance of the sharemarket in the past couple of months demonstrates.

It’s the opposite of stagflation – high inflation/low growth - which is the worst thing for investors. Low inflation and low-interest rates couple with solid, if not spectacular, growth is the best thing: valuations are supported and earnings rise.

There are two caveats: first, low interest rates and high growth encourages people to borrow, and there’s already an awful lot of debt around, and second, trade wars are essentially stagflationary, because tariffs put prices (inflation) while slowing consumption and growth.

I’ll discuss the prospect of trade war more fully in the next item, but at some point the debt is going to catch up with us.

I’m not sure how, or when, this happens but without inflation to eat it away, and without wage growth to allow it to be repaid, the debt is going to sit there like a ticking bomb and maybe eventually blow up (by which I mean have to be written off in some kind of mass default event – the GFC turned out not to be one of those because the banks all got bailed out).

In a way, that’s why the “demand-supply model of the labour market is fundamentally broken”, because people don’t go on the dole when they lose their job, they drive Ubers or deliver pizzas. They have to – they have a mortgage to pay.

The trouble with these sort of parties is that they can, and usually do, go for much longer than you expect.

It’s like the old gag about how the person went bankrupt: slowly, then quickly.

Trade War

I don’t have a lot to add to the trade war specifics, beyond observing that China’s response to Trump’s tariff histrionics is to calmly match him, tit for tat.

That tends to confirm that they are in a negotiation for an eventual trade deal with Trump aiming to create some things he can offer to give away in return for concessions from China.

Beijing is just trying to ensure that doesn’t happen by strengthening its own hand at the same time and to the same extent, so whatever Trump can offer to give away when the time comes, they can match.

But beneath all this is something deeper, that might mean the tariff tit for tat is just the beginning, and doesn’t lead to a new trade agreement between them at all.

China has been driving globalisation, and therefore the global economy, since 2001, when it joined the World Trade Organisation and integrated into the world’s supply chains, eventually coming to dominate them.

The next wave of China’s influence could be even greater than that, and certainly more challenging for the US – its massive “Belt and Road” initiative. Essentially China is planning to use its cash to open up the region – to essentially colonise Asia, the Pacific and the “Stans” in the way that European navigators, and then companies like the East India Company opened up, and colonised, Asia, Africa and South America in the 16th, 17th and 18th centuries.

In doing so China is on a collision course with the United States.

An important part of China’s ambition is to turn the renminbi into a regional currency. It’s already having some success with this, and is even trying to break the US dollar’s monopoly on global energy pricing by launching renminbi oil futures in Shanghai, signing renminbi oil contracts with Russia and renminbi gas contracts with Qatar.

More and more Asian trade, capital spending, and savings are starting to shift away from the US dollar and towards the renminbi, so the question is whether the US under Trump will take this lying down.

Perhaps the Administration will decide there’s not much that can be done, and the best they can do is win some concessions from Beijing on markets access and technology transfer before getting on with life.

But for the moment, markets are behaving as if the US dollar market is here to stay: emerging markets are getting crushed, American growth stocks are outperforming everything (still) and oil and commodities are rolling over.

Short Shorts

The bears are getting pummelled now.

Michael McCarthy of CMC Markets told me yesterday, in our interview for Talking Finance, that 67% of their trading clients are short the market, which amounts to 95% short by value. 95%!!

That is pretty wild. The market PE of 15 is a touch high it’s true, but that kind of crowded trade on the sell side is a buy signal if there ever was one. As Michael pointed out, those shorters will be scrambling to cover if, or rather when, the market goes higher. It’s the sort of thing that produces a big “blow-off top” as the bears capitulate.

On a specific note, the second most shorted stock is Domino’s Pizza, which has gone from $39 to $54 in the past two months, so there has been a lot of pain for the sorters in that one.

Something similar is going on in New York: analysts at Goldman Sachs reported last Wednesday that an in-house index comprised of companies with a high short interest had rallied by 8.1% in excess of the most popular hedge fund long “VIP basket” over the past six weeks. That represents a two standard deviation movement compared to the last five years.

And Jim Grant reported yesterday that the pain for shorters continued this week, with 65% short interest Rent-A-Center, Inc. receiving a takeover offer, and then GameStop Corp., of which 44% of the float is sold short according to Bloomberg, jumped nearly 20% from its morning trough after Reuters reported that the consumer electronics retailer is receiving buyout interest from private equity firms, including Sycamore Partners. 

As Grant’s concluded: “Exit bear, pursued by man.”

A World Cup Snippet

A bloke I know showed me this email he got from a UC Berkeley professor friend, who’s in Kazan, Russia, for the World Cup:

“Hi Ken,

You should be here!!  The Iranians have invaded the city. The Iranian women are completely wild! Not a skirt below mid-thigh in sight, let alone any of this head covering nonsense. Everyone is dancing in the street. The Iranians drank up a Volga-full of beer! Some bars have run dry!! So now the vodka is flowing... An Iranian gal just told me, vodka connects people... which I think is a parody on the old Nokia slogan... 

These sure aren't the Iranians that our media and politicians yap on about, nor is it the Russia that they yap about. The Russian people have everywhere put their best foot forward.  

The most fascinating factoid about Kazan: 48% Russian Christians, 47% mostly Muslim tatars. Not been a riot or a communal disturbance in a century.

The weather has been dreamlike.  

It is still possible to find good tickets. You shouldn't miss this spectacle.”

Next Week Off

I’m having next week off, and while I’ve banked up a few extra interviews so they will continue as usual through the week, there’ll be no Overview next Saturday, just the Catch Up email.

James Kirby will still do Money Café with someone else capable, and TCI's own Dave Thornton will produce a Talking Finance podcast.

Research and Diversions

Research

On high conviction, small cap investing. In March 2017 Ben Griffiths found himself in a deeply uncomfortable position. His small cap portfolio was badly lagging the benchmark. Sentiment had violently swung against his stocks and Griffiths was facing a tough decision – hold the current course or reposition the portfolio to chase returns. He decided to 'white knuckle it' and hold the current line.

Peter Martin, on the case for taxing women less than men. Seriously, but bear with him: “Most men will continue to work full-time regardless of what happens to what they take home, regardless of how much they grumble. Women are different. Most European and American estimates put the price elasticity of their labour between 0.4 and 1, meaning a 10 per cent boost in their take-home pay will lift their hours of work by between 4 per cent and 10 per cent.”

Man Vs Machine: the first live, public debate between a human being and an AI machine ended in a draw.

Interesting presentation (on video) by Charlie Aitken, about the rise of Asian consumers: “where technology and population collide”.

Forget trade wars, maybe we’ll have global fish wars, because fish are being driven to cooler waters by global warming – into waters controlled by other countries.

Electric buses will grow faster than electric cars.

Another “blockchain explained” thing, this time from Reuters. It’s pretty good.

Facebook’s privacy woes are going from bad to worse. This time, they’ve been caught giving companies “special access” to users’ data. Facebook had intended to shut down the program in 2015, which they did for the most part, but a few ‘special’ companies retained their “special access”.

Part of the problem with economic models of climate change is their overwhelming focus on the energy sector. But as David Roberts points out, “climate policy urgently needs to broaden its gaze from the power sector and start taking on other sectors. But models inhibit that. In models, the transportation sector and especially the industrial sector are resistant to carbon prices.”

With Martin Shkreli now in the clink, Todd Smith and Benjamin Bove have taken up the mantle of “Pharma Bros”. They’re shopping around a sales model that has led to a price increase of up to 4,116%.

Nobel laureate in economics James Buchanan, the brains behind the corporate attack on middle America. “If Americans really knew what Buchanan thought and promoted, and how destructively his vision is manifesting under their noses, it would dawn on them how close the country is to a transformation most would not even want to imagine, much less accept.”

Now more than ever we should remember the fragility of peace on the Korean Peninsula. That peace came close to being shattered when, in 1976, two US soldiers tried to trim a poplar tree, leading to their grisly murder by North Korean soldiers.

The pharmaceutical industry is selling drugs by inventing diseases, a practise known as “disease mongering.”

Fascinating interview with American journalist Seymour Hersh, who notably uncovered the My Lai massacre and its coverup. “The secret to Trump, I think, is he wants to be loved by The New York Times as much as by Fox News. He talks to them a lot, more than they tell you. He waits outside—apparently there’s a corridor from the press room to the bathroom, and he’s hanging around that corridor. He likes to yap.”

Lawrence Freedman’s innovative history of the future of war approaches this fundamental problem of predicting the future through a refreshingly non-technological lens. 

The lessons of Theranos, the huge blood testing fraud: “From time to time you will get duped. Everybody gets duped. Even Warren Buffett gets duped. It is in the nature of risk-taking. Optimism requires a degree of believing in things you cannot or have not verified. The key is an intentional focus on diversification, room for error, and avoiding single points of failure, particularly for big, non-insurable risks.”

Joseph Stiglitz: can the euro be saved? Yes, if Germany and other countries in northern Europe show more humanity and more flexibility. “But, having watched the first acts of this play so many times, I am not counting on them to change the plot”.

What makes authoritarianism possible? (And, yes, according to this book review, it CAN happen here).

Diversions

There used to be a floating hotel in Queensland, drifting over the Great Barrier Reef. It’s now in North Korea, would you believe.

On survivor bias in history. “History knows three things: What’s been photographed; what someone wrote down or recorded; and words spoken by people who historians and journalists wanted to interview and who agreed to be interviewed”

I think I’ll eat some worms: they’re actually quite nutritious, full of protein and Omega 3 fatty acids. “As with all food, the key to worms is preparation. There are two approaches. You can feed them roughage to clean out their system (or) simply boil the worms until the water is clear. You can dehydrate the worms, grind them down, and add them to flour. I like to mix my chopped worms with onion, garlic, and rosemary, then form small patties and fry them.”

A robot just operated on a human eye for the first time.

The mafia is more powerful than it’s ever been. "This organization has penetrated every single major financial center on the planet. It owns businesses, and it funds political parties all over the world. It is part of the fabric of modern life and that's actually the point. It's got itself to a point now where it's indispensable to the functioning of the modern world and it's very difficult to root out."

The ABC is NOT for sale (before the next election). Here’s an idea for a Liberal Party approved lineup.

Gross, Bill! Bill Gross, the bond king and founder of Pimco, who lost his beloved 13,819- square-foot Laguna Beach home to his ex-wife in their marriage break-up, used foul-smelling sprays to leave the place a stinking mess — and placed dead fish in the air vents, a “disgusted” Sue Gross claimed in court papers last week.

Nice compilation of dad reflexes videos.

https://www.youtube.com/watch?v=R6__QYkV_qs

The metaphysics of water: Lakes, river, the ocean — they spur us to reckon with the immense and the unknown, to confront life’s fluidity.

The Gonski panel is the chorus and we are the audience. The play is the ongoing tragedy of Australian education.

The price of beer around the world (infographic).

World’s Top 50 Restaurants 2018, full list (Attica in Melbourne jumped from 32 to 20).

Why does the Top 50 Restaurants list still get it so wrong? (It’s an ode to European-esque tasting-menu restaurants run by men – I agree! Although I do like Attica very much).

This looks like a fantastic new device. I want one! It’s a tablet that works like paper.

TCI member Andrew Grant sent me this video of Andre Rieu with a young singer named Amira Willighagen, saying “I know you are a busy man up to your eyes in shit emails! But please find the time to listen to this AND WEEP!” He’s right - it’s incredible! She sounds like a mature adult – with a magnificent voice.

https://www.youtube.com/watch?v=s9PQ7qPkluM

Jeff Buckley made it past 27, but not by much, drowning in the Mississippi River at age 30. "Why would you even put your toe in that? But it's typical Jeff. He was a butterfly, you know? He was just like: 'Go with it.'"

It’s been revealed that in the waning years of WW1, Britain tried to knock off Germany’s leader, Kaiser Wilhelm II.

The fraudulent life and times of New York socialite Anna Delvey - a story that would make John F. Fitzgerald proud.

Philip Glass on the music of time: “When I’m on a tour with the dance company we work in a different-sized theater every night. The first thing the dance company does is measure the stage. They reset the dance to fit that stage. You also have to reset the time of the music: In a larger theater, you must play slower. In a smaller theater, you have to play faster.”

Speed chuting, the art of competitive water sliding. "It's all about the friction, dude."

A doctor on the benefits of castration. “Gelding animals takes testosterone out of their development, making them less aggressive and more biddable, but also bigger. Early Assyrian and Chinese civilizations transposed this knowledge to humans."

Nick Murphy turns 30 today. He used to be a friend of my son Chris, probably still is except they don’t see much of other anymore. About 10 years ago, Deb and I saw him busking at Camberwell Trash and Treasure market one Sunday morning, and told him we thought he’d be a big star. He demurred, but I think he quietly agreed. Anyway, he did turn out to be a big star, but made the mistake of calling himself Chet Faker for some reason. Eventually he gave up on that and in 2016 went back to being Nick Murphy. Here’s his Wikipedia page, with discography, and here he is doing one of his recent hits, Medication.

https://www.youtube.com/watch?v=KClMzh5oZmg

One for the chess players: a “smothered mate” is possible!

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.

https://www.youtube.com/watch?v=WGFchQxue4s

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

Australia: End of Financial Year lull

• The End of Financial Year (EOFY) may be approaching, but tier-1 economic data in Australia is scarce this week. The latest update on Aussie household finances will be keenly observed given the laser-like focus of the Reserve Bank and economists on the biggest driver of economic growth – household consumption.  
• The week kicks-off on Tuesday with the latest weekly reading on consumer confidence by Roy Morgan and ANZ. The number of optimists currently outweigh the number of pessimists. Improving job security, potential personal income tax cuts and EOFY sales have boosted consumer sentiment. That said, rising petrol prices, the weaker Aussie dollar, anaemic wage growth and falling home prices have weighed on household views.   
• Also on Tuesday the Reserve Bank Head of Payments Policy, Tony Richards, speaks at the Australian Business Economists (ABE) event on cryptocurrencies.
• On Wednesday, the ABS releases the March quarter publication Engineering Construction Activity. While the ‘top level’ results have already been published, the publication goes into more detail about where the work is being done and how much activity is still to be completed.
• On Thursday the ABS releases the Finance & Wealth publication. The publication contains a raft of indicators such as household debt and wealth and sectoral holdings of financial assets such as foreign ownership of shares and bonds.
• Total household wealth (net worth) stood at a record $10,192.3 billion at the end of December, up $191.7 billion or 1.9 per cent over the quarter. In per capita terms, we estimated that wealth rose to a record $411,229 in the December quarter. And foreigners held a record $581.4 billion of Aussie shares in the December quarter or 30.4 per cent of the total.
• On Thursday the Bureau of Statistics releases the latest data on job vacancies – a key leading indicator of the job market. Job vacancies rose by 4.3 per cent to a record 220,900 in the three months to February. Job vacancies are up 19.3 per cent on a year ago – the strongest annual growth rate in over seven years. Compositionally, jobs growth has been led by the health services, education and construction-related industries. Near-record female participation in the workforce is lifting part-time jobs growth.   
• The Reserve Bank also issues the May Financial Aggregates publication on Friday. Most interest is in the estimate of private sector credit (effectively loans outstanding) but measures of money supply are also released. Private sector credit (effectively outstanding loans) rose by 0.4 per cent in April after a 0.5 per cent rise in March. Credit was up 5.1 per cent over the year. Bank deposits rose just 2.5 per cent over the year to April.
• Also on Friday new home sales data for May is scheduled to be released by the Housing Industry Association.

Overseas: US economic growth and China manufacturing activity data dominate

• Over the coming week US economic growth, the US Federal Reserve’s preferred inflation measure, the core personal consumption expenditure deflator, and Chinese profits and manufacturing data are all released.
• The week begins in the US with the release of two influential regional activity gauges from the Federal Reserve Banks of Chicago and Dallas on Monday and Tuesday.
• Also on Tuesday, housing data comes into focus. New home sales are forecast to lift by 0.6 per cent in May to around 666,000 units. And a 0.2 per cent gain in home prices is projected in April, bringing the annual growth rate for the S&P/Case-Shiller 20-city gauge to 6.5 per cent. US home prices grew at the fastest quarterly rate since 2006 in March. The regular weekly data on chain store sales rounds-out the data.
• On Wednesday, Chinese industrial profits data are issued for May. Profit growth rebounded strongly by 21.9 per cent over the year to April on the back of a favourable base effect and strong sequential growth. Unwinding of the Chinese New Year holiday effect contributed to the acceleration of revenue growth and industrial profit growth.
• Also on Wednesday there’s a data deluge in the US. The Richmond Fed Manufacturing Index, Conference Board consumer confidence, trade, durable goods orders and the regular weekly data on mortgage finance are all issued. US consumers' assessment of current economic conditions is at a 17-year high. An overall US trade deficit of US$67.3 billion is expected in May, up from US$68.2 billion in April. And a key measure of business investment, durable goods orders, is tipped to lift by 0.2 per cent in May after a 1.6 per cent fall in April.
• On Thursday the final estimate of US economic growth (GDP) for the March quarter is released. No change in the annualised growth rate at 2.2 per cent is expected. Annual retail sales growth has picked-up to 5.9 per cent over the year to May, implying that the ‘soft patch’ in household consumption in early 2018 is behind us.  
• Also on Thursday in the US is the regular weekly data on new claims for unemployment insurance.
• On Friday influential regional gauges from the Federal Reserve Banks of Chicago and Kansas are released. The personal income and spending report is also issued. The Fed’s preferred measure of inflation – the personal consumption expenditure deflator – will be keenly observed. The deflator is expected to increase by 0.2 per cent to an annual growth rate of 2.1 per cent in May.
• On Saturday China’s manufacturing and services purchasing managers’ indexes are released. Manufacturing activity rose in May to the highest level since September 2017. Solid growth momentum, unseasonally hot weather, and rising upstream commodity prices may have contributed to the increase.

Last Week

By Shane Oliver, AMP Capital

Investment markets and key developments over the past week

• The past week saw geopolitics continue to cause gyrations in markets with political tensions around immigration in Germany and Trump upping the ante on trade with China. This saw most major share markets fall, particularly in Europe and China and at the same time emerging markets remained under pressure not helped by the rising $US fuelling fears about a dollar funding crisis. Australian shares bucked the global lead though. Safe haven demand saw bonds mostly rally, except in Italy where worries resumed. Oil rose but metals and iron ore fell not helped by trade worries. This also saw the $A break below $US0.74 as the $US continued higher.
• Despite the trade war threat Australian shares rose more than 2% over the last week and made it to their highest level since early 2008, but is it sustainable? Australian shares have been boosted by a rebound in financial shares which had become oversold the previous week as bargain hunters snapped them up for their dividends, a boost to consumer stocks from the passage of the Government’s income tax package and strong gains in defensives and yield sensitive REITs. This has left the ASX 200 on track for our year-end target of 6300, assuming our base case of no major trade war is correct. However, the road between now and year end is likely to be rough with a high risk that the trade skirmish gets worse before it gets better, and worries around Trump, Fed rate hikes, China, emerging markets and Australian property prices all likely to cause a rough ride. Given that China takes one third of our exports the local market would be vulnerable should the trade war escalate significantly.
• Emerging markets under pressure but this is not 1997-98 all over again. From their highs early this year EM shares and currencies are down around 10%. The plunge reflects a combination of country specific problems (eg Turkey, Brazil and South Africa), concerns that the rising $US will cause a dollar funding crisis for emerging countries with significant $US debt, worries that they will be adversely affected by any global trade war and repositioning after investors loaded up on EM assets with a 65% rally in EM shares from early 2016 to early this year. The weakness could have further to go as many of these concerns remain, but it’s unlikely to be a rerun of 1997-98 or even 2015 as EM fundamentals around growth and external balances are arguably stronger than then and the rebound in the $US is likely to be limited.
• Trump’s further ramping up of the trade skirmish with China (from tariffs on $US50bn of imports plus another $US200bn should China retaliate and then another $US200bn if China retaliates to that) have significantly increased the risk of a full-blown trade war between the US and China - with a more significant economic impact. So far the bulk of the tariffs are just proposed so there is still room for a negotiated solution which remains our base case as that is what the US is seeking and China would prefer – otherwise the tariffs would have been implemented already. But there is now a high risk that some of the tariffs go into force before a negotiated solution is reached (which would be a short-lived negative for share markets), even though we still see the risk of a full-blown US-China trade war with deeper share market downside as being low at around a 10-20% probability. Key to watch for is the re-start of US-China negotiations ahead of July 6. It was noteworthy that central bankers Powell, Kuroda, Draghi and Lowe all raised the threat of a trade war as a significant risk to the outlook and by implication as a potential downside to interest rates.
• Expect measures to strengthen the Eurozone at its summit on Thursday and Friday, but will it be enough. Progress in this direction has been given a big push by French President Macron and German Chancellor Merkel supports many of his proposals. Expect progress on a banking union, measures to strengthen the European Stability Mechanism, possibly a start to a Eurozone budget, some agreement on an unemployment stabilisation fund and a strengthening of European Union border control enforcement. Solving the immigration issue is critical if Merkel is to head off a potential split with her Interior Minister who leads the Bavarian Christian Social Union and is threatening border controls around Germany and to keep Italy onside. A split with the CSU would unlikely spell the demise of Merkel or the German coalition Government as Merkel could get support from the Greens, but Merkel and her party would prefer to retain support from the CSU. A more integrated Europe would be positive for Eurozone assets including the Euro, but no progress would be bad.
• The Australian Government got a big win with the Senate passing its personal income tax package. However, the impact on consumer spending is likely to be trivial as the tax cuts for low and middle income earners don’t kick in until after taxpayers do next year’s tax return after June 2019 and are only around $10 a week which maybe buys two cups of coffee and the tax cuts for middle to higher income earners won’t be of any significance until next decade and just give back some bracket creep. So a surge in retail stocks on the news may have got a bit ahead of itself.
• Along with slow wages growth and falling house prices in Sydney and Melbourne there are two other drags on Australian households: rising petrol prices and potentially higher mortgage rates. The rise in petrol prices to around $A1.50/litre has pushed the typical Australian household’s petrol bill up by around $12 a week over the last two years.
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  Short term bank funding costs continue to rise in Australia pointing to potential upwards pressure on some borrowing costs. While US short term funding costs have come down, they have risen further in Australia. The reason for the divergence remains unclear but may be related to a desire to lock in funding ahead of the financial year end (after the squeeze into the March quarter end), the Westfield takeover and regulatory reforms including the impact of the Royal Commission. Whatever the reason the longer its sustained the more it will pressure Australian banks to raise some mortgage rates as banks source 20% of their funding from this source.

  
  Source: Bloomberg, AMP Capital

Major global economic events and implications

• US economic data remains mostly solid. The Philadelphia regional manufacturing conditions index fell in June but remains very strong. Existing home sales fell but home builder conditions remain strong, housing starts and home prices rose, the leading index rose and jobless claims remain ultra-low suggesting unemployment will head down further towards 3%.
• Japanese core inflation (ie, ex fresh food and energy) fell further in May to just 0.3%yoy highlighting that the Bank of Japan’s ultra-easy monetary policy has a long way to run yet.
• China is cutting taxes to help boost consumption (with 80% of urban workers to benefit) & the State Council signalled cuts to bank required reserve ratios to boost lending to small business.

Australian economic events and implications

• ABS March quarter home price data confirmed the softening in the housing market led by Sydney with Melbourne slowing too. Private sector surveys point to weakness having continued in this quarter. Our assessment remains that Sydney and Melbourne prices have more downside spread over the next 2-3 years as tighter bank lending standards, rising supply and deteriorating capital growth expectations impact with prices likely to see a total top to bottom fall of 15%. Perth and Darwin prices are likely at or close to the bottom, the boom in Hobart may have a bit further to go and Adelaide, Canberra and Brisbane are likely to see moderate growth. While a house price crash is a risk continued strong population growth in Australia of 388,000 people last year led by Victoria is one reason why this is unlikely.
• Meanwhile skilled vacancies fell for the third month in a row in May suggesting employment growth may be slowing (other indicators don’t point to this though) and the minutes from the RBA’s last meeting added nothing new. Our assessment remains that the RBA will be on hold out to 2020 at least and weak home prices, along with sub-par growth, uncertainty around consumer spending and low inflation and wages growth are the major reasons for this.

What to watch over the next week?

• Geopolitics will remain a focus in the week ahead with the US and China needing to start negotiating again to have any chance of heading of the July 6 scheduled start for US tariffs on imports from China and the European summit on Thursday and Friday taking on added significance given expectations of progress towards a strengthening of European integration and solving the immigration problem. 
• On the data front in the US expect a rise in new home sales (Monday), further gains in home prices and continued strength in consumer confidence (Tuesday), a rise in core durable goods orders and pending home sales (Wednesday) and strong personal spending data for May with a rise in the core personal consumption deflator to 2% year on year (Friday) which will leave it at the Fed’s target.
• Eurozone inflation data for June to be released Friday will no doubt be watched closely but with core inflation likely to fall back to just 1% year on year its likely to reinforce expectations for the ECB to leave rates around zero for a long time. Business and consumer confidence data will also be released.
• Chinese business conditions PMIs for June due to be released on Saturday June 30 will be watched for any sign of the slowing evident in activity data for May.
• Japanese labour market and industrial production data will be released on Friday.
• In Australia, it will be a relatively quiet week with ABS job vacancies data (Thursday) likely to show some slowing and credit growth (Friday) likely to remain moderate with ongoing weakness in investor credit.

Outlook for markets

• While we continue to see share markets as being higher by year end as global growth remains solid helping drive good earnings growth and monetary policy remains easy, we are likely to see more volatility and weakness between now and then as the US trade threat could get worse before it gets better and as worries remain around the Fed, President Trump in the run up to the US mid-term elections, China, emerging markets and property prices in Australia.
• Low yields are likely to drive low returns from bonds. Australian bonds are likely to outperform global bonds helped by the relatively dovish RBA.
• Unlisted commercial property and infrastructure are still likely to benefit from the search for yield, but it is waning.
• National capital city residential property prices are expected to slow further as the air continues to come out of the Sydney and Melbourne property boom and prices fall by another 4% this year, 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%.
• The $A likely has more downside to around $US0.70 as the gap between the RBA’s cash rate and the US Fed Funds rate pushes further into negative territory as the US economy booms relative to Australia. Solid commodity prices should provide a floor for the $A though in the high $US0.60s.