The Week in Review: April 13, 2018

Volatility abounds, share market rebounds, and US-China relations.

Investment markets and key developments over the past week

  • Share markets rebounded over the last week, but volatility remained high. Trade war risks receded, however, there were growing concerns about a missile strike on Syria and the FBI raiding Trump's lawyer's office. The risk on mood saw bond yields, commodity prices and the Australian dollar rise.
  • Good news on the trade front as China continues down the path of opening its economy despite US tariff threats. Trump also responded favourably.But there is still a long way to go. China's President Xi Jinping addressed the Boao forum and was extremely positive in reiterating that China will lower tariffs on certain products, ease access for foreign investors, and strengthen protections for intellectual property. Yes, China is playing good cop (President Xi and Premier Li)/bad cop (with various underlings like Commerce Ministry spokesperson Goa Feng talking of Chinese retaliation if the US further escalates trade tensions) in this so far “phoney trade war”. To achieve a fair outcome for China, this must be done. But overall China is taking the high ground here in acknowledging its surplus with the US is unsustainable, continuing down a path of opening its economy while implicitly acknowledging the need to protect intellectual property. And President Xi's comment that cold war/zero sum mentalities are “out of place”, and that dialogue is the way to resolve disputes, clearly indicates it is open to negotiation with the US on trade. This issue has a long way to go yet and there may still be lots of sniping in public. But so far, Trump has praised President Xi's speech and said the tariffs may not be levied – however, the ball is now in his court to get the negotiations going formally.
  • Of course, the worry list for investors remains long. There has been another military strike on Syria, after yet another chemical attack looming large, and the Mueller inquiry is getting even closer to Trump. In terms of Syria, yes, the risk is significant – but stuff in the Middle East has been flaring up and down for years without much lasting impact on global financial markets. The Mueller inquiry is more of a slow burn reminiscent of Watergate, but the story hasn't changed. Unless Trump is shown to have done something really bad he won't be impeached/removed from office, and if he is, it will be rough for markets along the way but US economic policy won't change much under Vice President Mike Pence. Some might say it would be more peaceful – with no twitter grenades from the President!     
  • The last few weeks have seen lots of market gyrations driven by President Trump's comments. A week ago, he said he was considering tariffs on another $US100 billion worth of imports from China, now he says the tariffs may not be levied and he is considering re-joining the Trans-Pacific Partnership (TPP). A few days ago, he declared that missiles “will be coming” to Syria, but then a few days later they are still being considered. All these gyrations are just classic bargaining/Art of the Dealstuff that creates lots of volatility for traders. But for most investors it's a case of turn down the noise and stick to a well thought out, long-term investment strategy.
  • While the volatility could go on for a while, some things are worth noting regarding the direction-setting US share market. The lows reached in February have held after the retest of the last few weeks, the forward price-earnings (PE) ratio has fallen to a reasonable 16x, corporates are accelerating buybacks, and M&A and investor sentiment has become very negative as profit growth remains very strong. This all suggests scope for a bounce back if the news flow becomes a bit less negative. This would flow through to global share markets, including the Australian share market.
  • In Australia, tightening lending standards around tougher checks of borrower income and expense levels are upon us. At least one of the major banks has announced formal changes to their standards on this front, and for the last week I have heard multiple anecdotes of the extra hoops borrowers now must jump through to get a loan. The economic impact is likely to be a slowing in housing-related credit growth. Since the tightening will more likely hit marginal borrowers in Sydney and Melbourne, given higher home price-to-income ratios, it reinforces the downside to home prices in these cities and the uncertainty around consumer spending. It's also a de facto monetary tightening, and it will likely mean a lower outlook for the Reserve Bank of Australia's (RBA) cash rate with the pressure from rising short-term funding costs on mortgage rates. We are currently looking at a rate hike around February next year, but the risk is that this will be delayed into 2020. 

Major global economic events and implications

  • US inflation pressures are continuing to rise, with the US Federal Reserve on track for more hikes than the market is allowing for. Core producer price inflation rose 2.7 per cent year-on-year in the March quarter, and core consumer price inflation rose to 2.1 per cent (from 1.8 per cent) as the “Verizon unlimited data plan effect” from a year ago is dropping out. Over the last six months, core inflation has been running at a 2.6 per cent annual pace. The Fed's preferred core consumption deflator is running below the core CPI inflation rate, but it will be ticking up too as last year's mini bout of deflation drops out and capacity utilisation continues to tighten in the US. With the US jobs market remaining ultra-tight, and small business optimism remaining very strong, we remain of the view the Fed will hike four times this year. Market expectations for three hikes this year remain too dovish.
  • Eurozone industrial production fell again in February for the third month in a row, but business conditions PMIs remain strong and indicate it will bounce back. Meanwhile, the minutes from the last European Central Bank (ECB) meeting came across as somewhat dovish with concerns about the strength of the euro. There are no signs of an early exit from easy money or a rate hike here.
  • But not everyone is seeing inflation rise. Chinese consumer and producer price inflation fell in March providing no impetus for any People's Bank of China (PBOC) tightening. Chinese exports fell in March, but this mainly reflects distortions caused by the timing of the Lunar New Year with growth being very strong in the March quarter as a whole. The same goes for imports. 

Australian economic events and implications

  • Australian data was rather bland over the last week. The NAB business survey showed business conditions and confidence slipping in March, but that was down from unbelievably strong levels. Conditions and confidence remain solid. Consumer confidence fell slightly and remains below business confidence, likely to remain the case until wages growth picks up. Meanwhile, housing finance going to first home buyers has continued to improve, but is at risk from the current tightening in lending standards around income and expenses as they will have to stretch more to get a mortgage in the future. 
  • While the RBA's Financial Stability Review continues to highlight risks for global asset prices as interest rates rise, the risks regarding the Chinese financial system, and the risks around household debt in Australia, it sees housing-related risks as having diminished thanks to macro-prudential measures. More broadly, the RBA sees the resilience of Australian banks as improving and is not too fussed by the rise in short-term funding costs.
  • The Rider, Levett, Bucknall count of cranes being used for residential construction has started to fall, most notably in Sydney. However, approvals remain high so the crane count is likely to remain high for a while yet. Meanwhile, the reduction in residential cranes has been offset by a rise in cranes being used for office, hotel, retail and education construction.

Shane Oliver is the Chief Economist at AMP Capital.

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