Trying to Unwind the Unwinding, The 'Powell Put', Cold War, Bluescope, Buffett, Amazon, and more

Last Night's Markets
Trying to Unwind the Unwinding
The “Powell Put”
“Cold War!”
Bluescope
Buffett’s Letter
Amazon in Oz
The Event
Research and Diversions
Facebook Live
Next Week
Last Week

Last Night's Markets

Trying to Unwind the Unwinding

The S&P 500 dropped 1.6% on Thursday because President Donald Trump said he was going to slap a 25% tariff on steel imports, tweeting: “Our Steel and Aluminum industries (and many others) have been decimated by decades of unfair trade and bad policy with countries from around the world. We must not let our country, companies and workers be taken advantage of any longer.”

It’s been a rough week. For two days, the US market fell more than 1% a day because of Fed chairman Jerome Powell’s bullishness (meaning more rate hikes). The tariff announcement made three days. I presume that’s because tariffs mean higher prices, and therefore more rate hikes although it might be just because it’s a dopey idea.

As it happens I’m currently reading (for book club) The Unwinding: 30 Years of American Decline, by George Packer. It’s not an economic analysis, but a series of very detailed personal stories, some famous people, some obscure – a wonderful book, and I’m loving it.

The narrative that’s relevant this week is that of Tammy Thomas, a woman who grew up in Youngstown, Ohio, which used to be known as “Steeltown USA” – it had been the centre of America’s steel industry for 50 years.

Tammy never really had a chance because when she was a teenager in the late 70s and early 80s, the steel industry collapsed, with mills closing one after another.

'Black Monday' - September 19, 1977 - was when a large part of Youngstown Steel & Tube closed down following its merger with New Orleans-based Lykes Corporation. That event had a ripple effect, so that in 1979-80, US Steel closed down and then in the mid-1980s Republic Steel filed for bankruptcy.

By the mid 1980s, Youngstown, Ohio was effectively a ghost town.

So the American steel industry has been dead for a long time, killed not by Chinese imports, but Japanese, and by anti-pollution regulations, which Japan didn’t have then (but did later, so that China’s dirty plants were able to take over. Now China is trying to clean up its steel industry.)

It seems to me Trump is applying defibrillators to a body that not only has rigor mortis, it’s well decomposed.

So it’s likely that all the 25% steel tariff will do is raise US inflation. The existing steel mills that remain are largely automated these days, so that increased production won’t result in many new jobs.

In any case, building a new steel mill is a very big, long term proposition and needs more than two, or even six more years of Donald Trump. They’d be just getting commissioned when the next Democrat President started work and cut tariffs again.

The other thing tariffs do is raise money for the Government, since they are just taxes on imports, so maybe that’s the real purpose of what Trump is doing – it’s a tax increase to help offset the tax cuts.

After all, there simply is no problem for the tariffs to solve: the US labour market is tight as a drum. Check out these charts from a recent report by ANZ:

Would be better if there were more people employed in steel mills than what they are currently doing? Hardly. Better to import the steel from cheap labour countries and keep costs down.

On Thursday night I sat with Paul Keating at dinner and, as often happens with Keating, we reminisced about the 80s and 90s as he railed against the lack of “policy ambition” these days.

Basically he and Bob Hawke opened up the Australian economy and ended the “Deakin Settlement” of tariffs and centralised wage fixing. Whitlam had cut tariffs by 25% across the board and Hawke and Keating finished the job and then brought in enterprise bargaining to make the whole system work.

He didn’t say this on Thursday night, but the model was America, where the steel industry was in the process of shutting down and Silicon Valley was getting started, along with the great Wall Street finance boom that accompanied the decline in bond yields from 1981.

The Silicon Valley tech boom crashed in March 2000, and then revived itself, and the Wall Street finance boom crashed in 2007-08.

Australia replaced its manufacturing industries not with technology or finance, as America did, but with China-focused resources industries after 2001, when China entered the global trading system by joining the WTO.

That meant we didn’t have recessions when the tech boom collapsed in 2000 and the finance boom collapsed in 2008, as America did both times, so that Australia now holds the world record for years without a recession. But the result is that Australia’s debt to income ratio is among the highest in the world.

(That’s because recessions result in lots of debt getting written off – if you don’t have them, the debt just keeps on growing, especially since one of the ways of combating recession is low interest rates.)

Since Hawke and Keating opened up the Australian economy there have been about 150 papers and reports on how to get innovation and technology going in this country, including this year’s “Australia: 2030”, the subject of my interview with its author Bill Ferris a month ago and this article by David Thornton.

It is too glib to say this has never worked, in fact there is plenty of innovation going on in Australia – probably about as much as could be expected – it’s just not really moving the dial because the market here is too small and success in technology has to be global. And innovation in finance has been squelched by the banking oligopoly.

Our miners, on the other hand, are some of the best, most automated, in the world.

See below for a deeper discussion of globalisation, but it’s fair to say that Australia’s economic success is based on trade, at a time when trade is under attack.

Hawke and Keating opened the place up to make exporters more globally competitive, but domestic industries have not developed because the market is so small.

The main domestically focused industries are healthcare, education and construction, and they are taking over from mining as this chart from Citi Research shows:

Healthcare is essentially a demographic industry, based on the ageing of the population, education is basically an export industry, based on Chinese and Indian students, and construction is all about immigration.

In fact, the strength of the Australian economy, such as it is (2.5% GDP growth) is mostly due to population growth. Per capita growth is almost non-existent.

So there are two risks for Australia exposed by this week’s events: debt and trade.

The 'Powell Put'

The Trump tariff tweet was ‘strike 2’ for the sharemarket – strike 1 was Jerome Powell’s testimony to Congress two days earlier, in which he was bullish about the US economy.

It boils down to strike price for the “Powell Put”. Fed chairmen have long been referred to as running a “put option” for investors – ever since Alan Greenspan, and the “Greenspan Put”. Since then there has been the Bernanke Put and the Yellen Put.

What it means is that if, or rather when, the sharemarket gets into trouble, the Fed will bail them out – that there is a “put option” in the form of lower interest rates and money printing. It’s another way of saying “moral hazard”.

After Tuesday, it’s clear that the Powell Put has a lower strike price than his predecessors’ – that is, the sharemarket would have to get into more trouble and fall more than it would have before in order to be bailed out.

Powell actually came out and said he wasn’t perturbed by the latest correction or the increase in volatility, and went on to note that the economy is in very good shape and that there are “tailwinds” coming in the form of fiscal stimulus.

The sharemarket duly corrected again in anticipation of 4-5 rate hikes this year instead of 3-4, and also adjusting for the lower strike price of the Powell Put.

In answer to a question he was quite specific:

“At the December meeting the median participant called for three rate increases in 2018 … since then what we’ve seen is incoming data that suggests a strengthening in the economy and continuing strength in the labour market. We’ve seen some data that in my case will add some confidence to my view that inflation is moving up to target.

“So I think each of us is going to be taking the developments since the December meeting into account and writing down our new rate paths as we go into the March meeting and I wouldn’t want to pre-judge that.”

Note that “new rate paths”. He’s basically announcing that rates are going up more than the three times that the current Fed “dot plot” predicts.

Mind you the US economic signs are not all buoyant. In the past few weeks, 60% of data surprises have been negative and with a 13-year low for the savings rate (2.4%), there is no pent-up demand. Consumer confidence might be high (130.8 according to the Conference Board index) but consumers are effectively tapped out.

Auto and housing look quite soft, so the fiscal lift-off could be in the nick of time.

Some people are starting to talk about the possibility of stagflation, which would definitely be the worst possible outcome for investors, but I think it’s way too early to talk about that. Inflation is rising but it’s still low and the signs of economic softness have not flowed through to the aggregate data and still probably won’t because of the Trump tax cuts. So I really don’t think we’re going to get a re-run of the 1970s.

“Cold War!”

Obviously there are bigger issues at stake from Trump’s tariff policy than just the prospect of higher inflation.

This was coincidentally exemplified by The Australian’s amazing Page 1 headline on Thursday: “Cold war: Freeze on China ties”. It was a terrible beat up, based merely on the possibility that a couple of ministerial visits to Beijing were being delayed, but it indicates the fraught atmosphere around relations with China these days.

Some of that fire has been stoked by Clive Hamilton’s new book: “Silent Invasion: China's Influence in Australia”, and as it happens Dave Thornton and I have been working this week on an investigation into that issue, including interviews with Hamilton, Peter Jennings of the Strategic Policy Institute and David Brophy, the academic who (negatively) review the book this week.

You can listen to/read the interviews and Dave’s article summary here, but this is part of what Peter Jennings told me:

“I have a background in defence over many years, so when I see reports about for example, China’s use of cyber techniques to steal intellectual property from Australian firms or to spy on Australian government agencies, I recognise that that reflects a current reality. I wouldn’t agree that what’s happening here is just an exercise of paranoia, in fact I’d really say that for a number of reasons we’ve been extraordinarily naïve in Australia over the years to think that somehow this wouldn’t be happening to us.

And here’s a bit of the Clive Hamilton interview:

“I think Sam Dastyari is a very important window into it all, and it certainly was the thing that woke me up and I thought, my goodness what's going on here.  Here we have a number of Chinese or Chinese-Australian billionaires who've become the major donors to both of our political parties. And the question I ask myself is, well, what do they want?

“…the truth is that the belief amongst most of Australia's elites, especially in the business community and politics that China is our destiny because what matters above all else is our economic future. I just heard Bob Carr again saying exactly that. The belief that China is our destiny and therefore we must not do anything to upset Beijing is very deeply rooted. There are many people in Australia who believe that we owe a debt of gratitude to China because it kept buying our iron ore through the financial crisis. There are also a lot of Chinese netizens who also go online whenever Australia does anything they don't like and say "Why aren't we more grateful?" But that I think is the most powerful weapon that China has wielded.”  

The biggest question is whether Australia will have to choose between the United States and China at some point – between “security” and “trade”. Obviously everyone hopes we don’t have to, but if Trump’s steel tariff leads to some kind of trade war then that day might come sooner than we think.

On that subject, David Brophy told me:

“…there may come a crunch, and the timing of that really isn’t necessarily up to us which is why we need to be really level-headed in this situation and keep an eye on the genuine issues and not get caught up in fear mongering about a threat from China.”

Australia is a mouse at an elephant fight, of course, and mainly needs to keep its head down and try to stay out of the way, but there are very big issues at play as well – not just a power contest between America and China.

The bigger picture was well described this week in an oped by Mohamed El-Erian published in the Financial Review, headed “The Washington Consensus needs to be replaced”.

For those without an AFR subscription, let me summarise it.

The Washington Consensus was a set of 10 broad policy prescriptions for individual countries in pursuit of economic and financial globalisation. Simply put, the idea was that nations would benefit from market-based pricing and deregulation at home while fostering free trade and open cross-border capital flows.

I think it should be called the Hawke-Keating Consensus because they started it all with the floating of the Australian dollar in 1983, but we’ll let that pass.

Says El-Erian:

“…at a certain point, confidence in the Washington Consensus turned into something like blind faith. The resulting complacency, among policymakers and economists alike, contributed to the world economy becoming more vulnerable to a series of small shocks that, in 2008, culminated in a crisis that pushed the world to the brink of a devastating multi-year economic depression.

“Meanwhile, policymakers overlooked the economic, political, and social consequences of rising inequality – not just of income and wealth, but also of opportunity – thereby allowing the middle class gradually to be hollowed out, a trend that was exacerbated by both technological and non-technological developments. They also underestimated the risks of financial contagion and surges in migration flows. As a result, behavioural norms and rules lagged far behind realities on the ground them, and political polarisation intensified.

“…enthusiasm for economic and financial globalisation has faltered”. 

He concludes by saying that coming up with a new paradigm won’t be easy – it will be “analytically challenging, politically demanding, and time-consuming” – but it needs to be done.

As Percy Allan wrote to me in an email: “This is a very perceptive analysis that deserves wide circulation. It covers the main global challenges facing the Western Hemisphere.”

Bluescope

The Australian business most affected by the Trump steel tariff would be Bluescope, and there are both positives and negatives.

On one level Bluescope is a US steelmaker through Northstar. Citi analyst David Thackray wrote yesterday that “consensus expectations for Northsar steel-making spreads (2.1mtpa) are likely to lift materially”. Adding: “…we expect BSL will join US steel stocks … in a rally fuelled by materially higher spread expectations”.

Against that John Durie said in The Australian that BSL is worried that steel blocked from the US will be dumped in Australia. Bluescope sells 2.2 million tonnes of hot rolled coil annually in Australia, and John reckons that may now be under threat.

Yesterday the market took Thackray’s positive view and pushed up BSL’s share by 16c at lunchtime despite going ex a 6c dividend.

But I’d say there’s more to come on this.

Buffett’s Letter

Warren Buffett’s annual letter to Berkshire Hathaway shareholders came out last weekend, so it’s a bit old now, but as always there are some great quotes in it, worth passing on:

Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date. “Risk” is the possibility that this objective won’t be attained.

Stick with big, “easy” decisions and eschew activity.

I want to quickly acknowledge that in any upcoming day, week or even year, stocks will be riskier – far riskier – than short-term U.S. bonds. As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates

Our aversion to leverage has dampened our returns over the years. But Charlie and I sleep well. Both of us believe it is insane to risk what you have and need in order to obtain what you don’t need. We held this view 50 years ago when we each ran an investment partnership, funded by a few friends and relatives who trusted us. We also hold it today after a million or so “partners” have joined us at Berkshire.

There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.

Charlie and I view the marketable common stocks that Berkshire owns as interests in businesses, not as ticker symbols to be bought or sold based on their “chart” patterns, the “target” prices of analysts or the opinions of media pundits. Instead, we simply believe that if the businesses of the investees are successful (as we believe most will be) our investments will be successful as well. Sometimes the payoffs to us will be modest; occasionally the cash register will ring loudly. And sometimes I will make expensive mistakes. Overall – and over time – we should get decent results. In America, equity investors have the wind at their back.

Though markets are generally rational, they occasionally do crazy things. Seizing the opportunities then offered does not require great intelligence, a degree in economics or a familiarity with Wall Street jargon such as alpha and beta. What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period – or even to look foolish – is also essential.

And here are some lessons for Australian investors in Warren Buffett’s timeless wisdom:

1. Bonds can be risky: The bond market has been a boon for leveraged Aussie companies. Now the bond market is clearly riskier. There’ll be more capital raisings by this year as companies try to get their debt down.
2. Betting on people vs betting on assets: Some of Australia's best CEOs delivered some of the best reports in this profit season. They include Alan Joyce at Qantas, Paul Perreault at CSL, Hugh Marks at Nine Entertainment and Peter Coleman at Woodside.
3. Be willing to look foolish: It was foolish at times in 2017 to be underweight some of the expensive bond sensitive stocks, like banks. But it was anything but foolish to be out of them during the current reporting period.
4. Look for a sensible price: Stock performance during the reporting season was clearly skewed towards those with lows PE ratios. You should tilt your portfolio to cheap companies as they are likely to gain most as the earnings expansion continues.

By the way the first and last points will persist. It would be wise to assume that the US bond rate is going 3% and beyond, possibly to 4-5%, over the next few years.

That will change the structure of investing around the world, so that “bond sensitives” (banks, REITs etc) will struggle and only those companies with rising earnings will be worth investing in, whether for income or growth.

Amazon in Oz

Amazon has picked up the pace in Australia in the past few weeks.

You might remember that when they launched last December, everyone was asking: “Is that all there is? Is that it?” That’s because its prices were high and the range was limited. Well, they were just taking their time.

Morgan Stanley’s Tom Kierath and his team have done some work on Amazon’s offering now, to coincide with the launch this week of the “Fulfilment by Amazon” service – basically a logistics service to vendors.

Amazon is now offering free delivery on 27,000 SKUs (stock keeping units) with a value of over $49 and it lifted the total number SKUs offered on its site from 1.4m to 4.4m between December 5th and January 29th.

That was subsequently reduced back to 1.5m “as it has streamlined to focus on products that are actually selling”.

More important have been the price reductions:

What happens next?

Amazon has said it will launch Amazon Prime mid-2018, which will bring together its existing Amazon Prime Video (US$5.99/ month) and Amazon Music (A$4.99 / month) offer as well as unlimited 1-2 day delivery.

Says Morgan Stanley’s Kierath: “Given the pace at which it has improved its offer it's difficult to predict how quickly retailers will be impacted, but based on the improvement to date we think that it is increasingly likely that retailers will need to lower prices and invest in improving delivery times/cost.”

The Event and the App 

Time’s running out to get your tickets for The Constant Investor LIVE! 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. Click here for all the information - I'd love to see you there.

And after all the promises, our smartphone app is finally out and it's well worth grabbing on your iPhone, iPad, or Android device. You can download it to your phone or tablet by clicking on either the Apple App Store or Google Play Store buttons below, or search The Constant Investor in the Apple App Store or Google Play Store.

Research and Diversions

Research

The three things that good fund managers never do.

We keep hearing about the tulip mania in Holland of 1636/7, especially to compare it with Bitcoin. In fact most of what we’re told about it is wrong. It’s a myth.

An important interview about artificial intelligence with a science fiction writer: computation and thinking are different things. The convergence of machines and humans will never happen because “the ambition is basically metaphysical. It will recede over the horizon like a heat mirage”.

The United States pioneered modern life. Now epic numbers of Americans are killing themselves with opioids to escape it. The easy availability of Fentanyl on the black market, and OxyContin on prescription, have fuelled the epidemic. “If Marx posited that religion is the opiate of the people, then we have reached a new, more clarifying moment in the history of the West: Opiates are now the religion of the people”

Will the Olympics cost themselves out of existence?

Rome has decided to ban diesel cars by 2024.

Russia hacked the Olympics and tried to make it look like North Korea did it

Trump’s takeover of American conservatism is complete and total.

Manafort Left an Incriminating Paper Trail Because He Couldn’t Figure Out How to Convert PDFs to Word Files: There are two types of people in this world: those who know how to convert PDFs into Word documents and those who are indicted for money laundering. Former Trump campaign chairman Paul Manafort is the second kind of person….

Apparently Robert Mueller is digging into Trump’s finances, going way beyond the “red line” that Trump set early on. Mind you, I’m not sure how this person knows that, since Mueller is not leaking.

Trumpocracy: Tracking the Creeping Authoritarianism of the 45th President. Conspiracy theories, attacks on the press, praise for tyrants, and other troubling moves by the Trump administration.

Stephen Colbert on all this.

On the other hand … Trump is now speaking up in favour of gun control, making lawmakers squirm.

Perfectionism has become a hidden epidemic among young people. They need to be given a break.

Why is inflation so low? Another piece from central bank economists (from the St Louis Fed) speculating about the causes of low inflation – that is, they don’t know. No one does.

Peak trademark: trademark law has long assumed that there exists an inexhaustible supply of unclaimed trademarks that are at least as competitively effective as those already claimed. Actually, it turns out that the supply of good trademarks is, in fact, exhaustible and that we have very nearly exhausted it. Most of the good words have already been claimed.

“Much like gyms, which make the bulk of their profits off people who sign up for memberships but never work out, self-storage facilities profit off people who think they’re going to store some old junk while they get their life together, before ultimately realizing it’s easier to throw $87.15 at their local self-storage corporation each month than it is to actually sort through all their stuff.

Yanis Varoufakis’s Adults in the Room: My Battle with the European and American Deep Establishment is an important contribution to the library of modern politics, as a case study in the limits of radicalism and the forces that hold the status quo in place.

Shopping malls are the centre of suburban life. We’ll miss them when they are gone.

JP Morgan and Bank of America detail the “disruptive threat” to their businesses of cryptocurrencies.

Great interview with linguist and cognitive scientist, Stephen Pinker. For example: “For all the obsession with inequality over the last decade or so, it really is not a fundamental dimension of human well-being. If Bill Gates has a house that is 30 times the size of mine, it still doesn’t affect how I live my life; unless you assume that there is a fixed pot of money and the more some people have, the less others have. What matters morally is not inequality but poverty: how well people are at the bottom.” 

Face recognition is poised to become one of the most pervasive surveillance technologies, and law enforcement’s use of it is increasing rapidly.

Diversions

This 27-year-old idiot has spent ten years tattooing his body entirely black! - including the inside of his mouth and the whites of his eyes.

Will Self, in praise of difficult novels: “some texts are clearly going to be a better jungle gym for the mind than others—and just as you never put on much muscle mass with a limp-wristed workout, so no one ever got smart by reading… Dan Brown.”

The architectural sacking of Paris: “French architects are awful, and French leaders have no taste. This is a dangerous combination.” 

The best (most diverse) food cities in the world. Sydney is 14th; Melbourne is 6th. Ha!

Alone in a crowd: the hidden landscape of menopause.

Fantastic Andrew West interview about Billy Graham, with historian Roy Williams. Apparently 30% of Australia’s population came out to see him in 1959.

How to build a human brain – “it’s like making a cake”.

Monica Lewinsky on how the #MeToo movement has changed her thinking.

Consider the lobster. Switzerland has made it illegal to boil a lobster alive. I think this is a big moment – there will be, and should be, more of this.

Happy Birthday Jennifer Warnes. She actually introduced me to Leonard Cohen, for which I’ll be forever grateful. I heard her sing “Famous Blue Raincoat” before I heard Cohen sign it, or any other song. I wept the first, oh, ten times I heard it. Damn! It just happened again. Deb and I once walked across Manhattan in the rain to see Clinton Street, but there wasn’t music playing all through the evening.

And you treated my woman to a flake of your life
And when she came back she was nobody's wife

And…

Yes, and thanks, for the trouble you took from her eyes
I thought it was there for good so I never tried

Jennifer Warnes also did a pretty fine “First We Take Manhattan”. Shivers up the spine.

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

Economic growth data; and the Reserve Bank meets

• Top-tier economic data features prominently in the coming week with economic growth, building approvals, and retail trade all being released. The Reserve Bank Board also meets.

• The week kicks off on Monday with the Australian Bureau of Statistics (ABS) releasing the December quarter Business Indicators publication, which includes data on profits, sales, inventories and wages.
• Also on Monday data on building approvals, new vehicle sales, ANZ job advertisements and surveys on the services sector are all released in a hectic start to the week.
• On Tuesday the Reserve Bank Board meets. No change in monetary policy settings is expected. Interest rates are firmly on hold until at least the end of 2018 due to retail deflation and modest wages growth.

• Also on Tuesday, the ABS issues the broader trade data for the December quarter – the balance of payments and foreign debt figures. The current account deficit narrowed slightly to $9.1bn in the September quarter.
• Retail trade data for January is issued on Tuesday. Sales data has been volatile in recent months although the decline in December was largely expected after the biggest increase in sales in eight years in November. The pick-up in quarterly retail sales volumes should be a positive contributor to economic growth for the December quarter. Retail trade may have lifted 0.4 per cent in January.
• Also on Tuesday, Roy Morgan and ANZ release the weekly consumer sentiment data and the ABS issues the government finance data. The spending figures (consumption and investment) are a key input into the following day’s economic growth estimates.
• On Wednesday, the December quarter National Accounts are released. The main interest is in the economic growth figures (the change in GDP) but the data also includes other estimates such as household consumption. The economy probably grew by 0.6 per cent in the quarter and around 2.5 per cent for 2017.
• On Wednesday, the Reserve Bank Governor, Philip Lowe delivers a speech at the Australian Financial Review Business Summit in Sydney. The AiGroup releases its construction industry survey alsoon Wednesday.
• On Thursday the ABS releases international trade (exports and imports) for the month of January and a surplus of $600 million is expected.

Overseas: Spotlight on Italian election, US jobs and Chinese inflation data

• The week kicks off on Sunday with the Italian general election. The poll is generally regarded as the most important in Europe this year. The Italian economy is improving, but a hung parliament looks likely. Italian shares have been strong performers this year on diminishing bank concerns.
• On Monday, services sector activity gauges are released for both the US (ISM) and China (Caixin). Chinese business activity expanded at the quickest pace in seven years in January. The ISM expanded to its highest level in over twelve years.
• New order growth is accelerating in the US manufacturing sector, rising in six of the past seven months. Factory orders, however, expected to moderate in January when the data is issued on Tuesday.
• On Wednesday the US Federal Reserve issues its Beige Book on economic conditions across twelve regions. 
• Also on Wednesday private sector companies (ADP survey) are tipped to have hired a further 195,000 job seekers in February. And the US trade balance report is released. A deficit of US$54.1 billion is forecast in January, up from the US$53.1 billion deficit in December, a 9-year high. Imports have been strengthening. And consumer credit is tipped to increase to US$20 billion in January, up from US$18.45 billion in December.
• Atlanta Fed President Raphael Bostic speaks on the US economic outlook on Wednesday.
• On Thursday we get the latest read on China’s trade balance. China’s imports surged by 36.9 per cent and exports by 11.1 per cent year-on-year, respectively in January. The trade surplus stood at US$20.4 billion.
• Inflation data is released in China on Friday. Both consumer and business price indexes slowed in January. Factory prices, which feed into the prices that export customers pay, are continuing to decelerate. Prices rose at an annual growth rate of 4.3 per cent in January on lower commodity price growth – a third consecutive monthly decline – weighing on industrial profits.
• Consumer prices softened to an annual growth rate of 1.5 per cent in January. It is expected that the Consumer Price Index picked-up in February after the Lunar New Year base effects pass through from the previous month. Food and non-food inflation will keenly observed.
• Also on Friday the all-important US employment report for February is released by the Bureau of Labor Statistics. While the unemployment rate is forecast to remain at 16-year lows of 4.1 per cent, an additional 190,000 jobs are expected to be created. All eyes will be on average weekly earnings with an increase of 0.3 per cent expected. Annual wages growth is the strongest in eight years, sparking inflation concerns in markets.

Last Week

By Shane Oliver, AMP Capital

Investment markets and key developments over the past week

• Share markets turned back down over the last week as inflation and Fed fears continued to ramp up on the back of Fed Chair Powell’s Congressional testimony not helped by President Trump’s announcement of tariffs on US imports of steel and aluminium. The tariff announcement weighed a bit on the Australian share market with worries about the direct impact on Australian producers and the threat of a trade war, but as we saw early in February it continues to be relatively resilient. Bond yields perversely declined on the back of safe haven demand (just as we saw earlier in February when shares fell sharply) and commodity prices were mostly soft with oil, metals and iron ore down. The Australian dollar also fell as expectations for Fed rate hikes moved up.
• We remain of the view that the pullback in share markets seen last month is a correction as opposed to the start of a major bear market, but we may not have seen the last of February’s share market lows. With US inflation and Fed expectations still moving higher and Trump adding to the inflationary pressure in the US with tariff hikes, share markets are likely to remain volatile in the short term with a high risk of seeing a re-test of February share market lows.
• Trump’s decision to impose a 10% tariff on imported aluminium and 25% on steel, is bad policy at a bad time and will only add to the risk of a trade war. While not as bad as the 35% tariff on Chinese imports he talked about in the election campaign it’s still bad policy because tariffs don’t work - a review of the 2002 8-30% steel tariffs found “the costs of the Safeguard Measures outweighed their benefits”. And its bad timing because the US economy and labour market is already running hot. It doesn’t need more “help”. This will only add to production costs and inflation in the US and further increase the pressure on the Fed. In terms of whether we see a global trade war or not, China is the country to watch but apart from loudly protesting its likely to hold fire in terms of retaliation preferring to work with other countries in mounting a WTO challenge and develop its image as the “good guy” in terms of supporting free trade. Out of interest the bulk of China’s aluminium and steel exports don’t go to the US so the direct impact on China will be modest, which in turn should mean a relatively modest impact on Australian miners.
• Fed Chair Powell’s first Congressional Testimony was slightly hawkish. While Powell’s prepared comments were pretty balanced his answers to questions indicated he wasn’t concerned about a bit of financial market volatility and more significantly that he is leaning to four rate hikes this year. Since the December Fed meeting, which had three hikes in the so-called dot plot, global growth and US fiscal policy have become tailwinds to US growth and confidence in the US outlook has increased. The dots may not get to four at the March FOMC because it would require four of the six Fed officials currently on three hikes to move to four and recent comment from Fed officials has had a more cautious tone. But I think that’s where they are ultimately heading. Our view has long been and remains that the Fed will do four hikes this year (possibly five!). The Fed will still be “gradual” but just less gradual that it has been so far this tightening cycle as the strong growth and inflation outlook mean that it has more work to do to get back to a now rising neutral rate. So markets still have to more adjusting to do with the US money market still only factoring in three hikes. This adjustment won’t go in a straight line, but it  means ongoing volatility as investors adjust to higher US interest rates and bond yields and should be positive for the US dollar as the Fed continues to tighten ahead of other central banks.
• Europe is back in focus this Sunday (March 4) with the outcome of the vote by Social Democratic Party members on the coalition agreement with Angela Merkel and the Italian election. While it will be close, the SDP poll is likely to support the coalition because they won’t want the alternative which may be another election at a time when they are polling behind the Alternative for Deutschland. A yes vote would clear the way for Merkel to work with Macron to further strengthen Europe. A no vote may be a negative for Eurozone assets, but it could just see Merkel attempt to run a minority government.
• The Italian election is a bit messier, with polling indicating that no single party or existing coalition will reach the 40% threshold to win government. Another grand coalition between Forza Italia and the Democratic Party or a centre-left coalition with the Democratic Party and the Five Star Movement would be the best outcome – but would only mean more of the same muddling along in Italy. A populist Euro-sceptic coalition between the Northern League and the 5SM would probably be the worst outcome but looks unlikely given their political differences. However, a populist right-wing coalition government including Silvio Berlusconi’s centre-right Forza Italia and the right wing Northern League looks marginally the most likely – but it wouldn’t be so good in terms of budget control and winding back reforms. The Italian election is unlikely to threaten an Itexit (an Italian exit from the Euro) in the short term, but it does run the risk of making Italy’s public finances worse than they already are with no progress in addressing Italy’s long-term competitiveness problems. Not great – but probably not enough to threaten the greater European integration agenda that Germany and France are likely to pursue (assuming SPD members back a coalition with Merkel). Assuming the outcome is another grand coalition, or a Forza Italia dominated coalition with the Northern League the market reaction is likely to be minimal.

Major global economic events and implications

• US economic data was a mixed bag over the last week. Home sales fell in January with higher mortgage rates and reduced mortgage interest deductibility probably impacting, durable goods orders were softer than expected, consumer spending was soft in January and the trade deficit was worse than expected. December quarter GDP growth also got revised down slightly but this was due to weaker inventories with final demand actually very strong. However, against this consumer confidence rose to its highest since early last decade and household disposable income rose strongly in January pointing to a bounce back in consumer spending, the ISM manufacturing conditions index rose to boom time levels, jobless claims fell to their lowest since 1969 and home prices are continuing to rise. The core consumption deflator which is the Fed’s preferred inflation measure remained at 1.5% year on year in January but its been running around 2% annualised over the last six months and looks likely to head higher on the back of the strong economy. All of which supports the Fed in raising interest rates four times this year and highlights the danger Trump is running in terms of tariff hikes on top of fiscal stimulus.
• The US December quarter earnings reporting season is now effectively done with profits up 16% for the year to December, earnings up 8% and expectations for profit growth this year revised up to 20.6%. Which is very supportive of shares, beyond uncertainties around the Fed and bond yields.
• Eurozone economic confidence fell in February but remains very high consistent with strong growth, bank lending to the private sector is continuing to accelerate and unemployment fell further to 8.6%. Meanwhile, core Eurozone inflation was unchanged in February at just 1% year on year which will keep the ECB patient in terms of thinking about when to start removing its easy monetary policy.
• Japanese industrial production fell surprisingly sharply in January, but the still robust Japanese manufacturing PMI indicates that it will bounce back. Meanwhile the labour market remains very strong with unemployment falling to the lowest since 1993.
• Chinese business conditions PMIs for February were a bit confusing with falls in the official PMIs but a small rise in the Caixin manufacturing PMI. Overall it looks like growth may be slowing in China, but only a touch. Our expectation remains for growth around 6.5% this year in China.

Australian economic events and implications

• In Australia, capital expenditure data provided more confidence that business investment has bottomed but the investment growth outlook remains soft. December quarter business investment was basically flat but with good growth in equipment and non-mining investment. The good news is that investment plans for both 2017-18 and 2018-19 were increased compared to those of a year ago. The disappointing news though is that the upswing in overall investment in prospect is modest as mining investment remains a drag (albeit a diminishing one) and its partly offsetting the improvement in non-mining investment. There is nothing here to bring forward RBA rate hikes. Other data was mixed with strong business conditions PMIs, moderate credit growth (with still weakening property investor credit) and another month of falls in house prices in February, driven by Sydney. Our assessment remains that Sydney and Melbourne property prices have more downside but that the total top to bottom fall will be limited to around 5-10% (with Sydney already down by 4.8%) in the absence of much higher interest rates or unemployment (both of which are unlikely).
• Solid broad-based profit growth with a good outlook will help the Australian share market, but it’s still lagging global profit growth. The December half profit reporting season is now done and has been pretty good. 46% of results have exceeded expectations (against a norm of 44%), 74% of companies have seen profits rise from a year ago (compared to a norm of 65%) which is the strongest since the GFC and 66% have increased dividends from a year ago with 26% keeping them flat which is a sign of ongoing confidence in the outlook. Reflecting the reasonable quality of results 59% of companies saw their share price outperform the market the day results were released (against a norm of 54%). Consensus profit growth expectations for this financial year remain around 7%, with resources upgraded slightly to 16% and the rest of the market downgraded to 5% (from 6%) owing to a downgrade to banks. Profit growth expectations for 2018-19 have been upgraded to 5% (from 4%) thanks to resources. This is good news and will underpin a rising trend in the Australian share market. That said local profit growth continues to lag that globally where its running around 14%.

[caption id="attachment_134567" align="alignnone" width="527"] Source: AMP Capital[/caption]

What to watch over the next week?

• In the US, the focus will be on Friday’s jobs report for February and specifically whether we will see a further pick up in wages growth like we saw in the January report and which kicked off a plunge in share markets. Expect a 180,000 gain in payrolls, a fall in unemployment to 4% and wages growth unchanged at its January level of 2.9% year on year. In other data expect the February non-manufacturing conditions ISM index (Monday) to have slipped a bit but to a still strong level and the trade balance (Wednesday) to show a deterioration. The Fed’s Beige Book of anecdotal evidence (also Wednesday) will be watched for ongoing signs of building inflation pressure.
• Both the ECB (Thursday) and Bank of Japan (Friday) are Iikely to remain on hold, basically staying on auto pilot for now with their ultra easy monetary policies. The ECB will be watched for signs of a taper in its quantitative easing program after September, but is likely to reiterate that rate hikes won’t occur until well after QE has ended which probably means around mid-2019. By contrast the BoJ is likely to reiterate that it has no plans to start winding back its ultra-easy monetary policy.
• In China, the key to watch in the National People’s Congress that commences on Monday is the balance between growth and reform particularly around financial deleveraging. The 2018 growth target is expected to be around 6.5%, but if its looks like the focus is shifting more towards reform and financial deleveraging implying a greater tolerance for weaker growth then this could raise concerns about China’s growth outlook. I wouldn’t be too fussed though as the tolerance for lower growth is likely to remain low given the risks around social instability. Chinese trade data (Thursday) is expected to show continued solid growth in exports of around 10% but a slowing in imports to 15% and CPI inflation (Friday) is expected to rise to 2%yoy, with a further slowing in producer price inflation to 4%.
• In Australia, the RBA (Tuesday) will leave rates on hold for the 19^th month in a row. Solid business conditions and jobs growth along with RBA forecasts for stronger growth and inflation down the track argue in favour of a rate hike. But weak wages growth and below target inflation, risks around the outlook for consumer spending and the still too high $A argue for rates to remain on hold or to be cut. And the cooling in the Sydney and Melbourne property markets provide the RBA with plenty of flexibility. So the RBA is likely to remain comfortably on hold. We don’t expect a rate hike until late this year at the earliest. RBA Governor Lowe in a speech on Wednesday is likely to reinforce the impression that the RBA is comfortably on hold for now.
• On data front in Australia, December quarter GDP data (Wednesday) is likely to show growth of 0.2% quarter on quarter or 2.2% year on year as net exports (due Tuesday) detract 0.7 percentage points from growth but this is offset by a bounce back in consumer spending and growth in business investment. Meanwhile, expect building approvals (Monday) to show a bounce after a big plunge in December, January retail sales (Tuesday) to show modest growth consistent with mixed to soft reports from retailers and the trade deficit (Thursday) to show an improvement to -$200m after a recent run of poor results.

Outlook for markets

• Volatility in share markets is likely to remain high and we may see a retest of February’s share market lows, with investors yet to fully digest the outlook for higher inflation and interest rates in the US, but the broad trend in share markets is likely to remain up 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 bond yields are likely to drive 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 remain 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 in January 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 RBA’s cash rate and the US Fed Funds rate goes negative this month. Solid commodity prices will provide a floor for the $A though.