High Risk Of A Pull Back

Originally published by AMP Capital

Investment markets and key developments over the past week

• While US shares were little changed over the last week other major markets saw solid gains helped by good news on trade. This included Australian shares which got a further lift from reasonable earnings results, more talk of rate cuts and upgrades to earnings growth expectations for resources stocks on the back of higher commodity prices. Bond yields were flat to up a little bit. Oil, gold and metal prices rose but iron ore prices fell back a bit but remain very high. The Australian dollar fell slightly despite a lower US dollar as rate cut talk continued.

• It looks like momentum is continuing to build towards a resolution of the US/China trade dispute. There is more to go – with memorandums of understanding being drafted around the major issues presumably to be signed off by President’s Trump and Xi – and this is unlikely to be resolved by the March 1 deadline. But an extension is likely and our view remains that some sort of deal is likely as its in both sides interests after the mayhem in business confidence and share markets last year’s trade war flare up contributed to.

• Business conditions PMIs were mixed in February – up in the US and Eurozone driven by services but with manufacturing conditions falling in the US, Eurozone and Japan. And Australia was weak. We still see the current environment as like in 2011-12 and 2015-16 – both of which saw shares fall 20% or so as PMIs fell only to then see a rebound. But at this stage we are still waiting for a clear rebound in PMIs which is leaving shares vulnerable to a pullback in the short term, although we expect policy stimulus to underpin stronger PMIs (and shares) into the second half of the year.

• Meanwhile the Brexit comedy continues with MPs now defecting from Labour and the Conservatives. Brexit was sold on a lie by the Brexiteers - that the UK could have its cake (free trade with the EU) and eat it too (without the EU’s rules and restrictions). Of course, this was never on as far as the EU was concerned, but it got the yes vote over the line. So, the referendum has left a mess to try and sort out (for a parliament that doesn’t have majority support for Brexit). The best way out of this mess would be to have another referendum as the British people would now have a better understanding of the facts. Anyway, this all has a way to go which is not great for the UK economy – but just remember that for the rest of us this is just a sideshow second order issue!

• It’s hard to get too excited at this stage by reports of Chinese restrictions on imports of Australian coal. 25% of Australian coal exports go to China and if there is a ban on all of this it could knock up to 0.7% off Australian GDP. This is very unlikely though as so far it looks like slower processing as opposed to a complete ban, it would violate the free trade agreement between Australia and China and in any case Australian coal exports can be diverted to other markets as China still needs the coal. It will be a bigger issue though if it signals deeper problems in Australia’s relationship with China.

Major global economic events and implications

• US data was mixed over the last week. Underlying capital goods orders, the Leading Index and manufacturing conditions in the Philadelphia region were all soft but jobless claims fell, home builder conditions rose and the composite PMI for February rose (with manufacturing down but services up). All of which is consistent with the Fed staying on hold.

• Meanwhile, the minutes from the Fed’s January meeting confirm its dovish shift on rates – with it seeing few risks to pausing rates and unclear as to whether it will raise rates later this year or leave them on hold - and in relation to quantitative tightening with the Fed heading towards ending its balance sheet reduction by year end. In terms of the latter expect some sort of formal announcement at the March meeting with a likely slowing (or taper) in the rate of QT and its end by the end of the year which will leave the Fed’s balance sheet far higher than previously expected. Of course, whatever it does will be contingent on economic conditions.

• The US December quarter earnings reporting season is now 90% done and was much better than feared. 72% beat on earnings with an average beat of 3.2% and 59% beat on sales. Earnings growth is running at 18.5% year on year for the quarter. But as can be seen in the next chart the level of surprises and earnings growth is down. US earnings growth is likely to be around 5% this year as the boost from the corporate tax cut drops out.

• At last some good news out of the Eurozone with the composite business conditions PMI for February up 0.4pts after falling through much of the last year. Manufacturing conditions fell further but this was offset by the more important services sector. Pressure remains on the ECB to provide more cheap bank financing – which looks likely to be announced next month – but it’s a good sign.

• The news out of Japan wasn’t so good though with a sharp fall in the manufacturing conditions PMI for February and soft data for machine orders, machine tool orders, exports and imports. Core inflation in February remained weak at 0.4% year on year.

Australian economic events and implications

• Australian data was a mixed bag with another strong jobs report, but wages growth still stuck at a low 2.3% year on year (or 2% were it not for the faster increase in the minimum wage) and a further decline in the CBA’s business conditions PMIs for February with very weak service sector conditions. There is no doubt that jobs growth has been and remains strong. But our assessment remains that it will slow going forward in response to reduced housing construction and soft consumer spending on the back of falling house prices resulting in an increase in unemployment and lower for longer inflation ultimatley providing the trigger for rate cuts later this year, starting in August (but they could come earlier).

• Speaking of rate cuts, RBA Governor Lowe’s (NYSE:LOW) parliamentary testimony and the minutes from the RBA’s last meeting didn’t provide a lot that was new – really just confirming the shift to a neutral bias on interest rates. But the minutes did further elevate the importance of house prices in relation to the RBA’s thinking on rates with the observation that if house prices were to fall “much further” it would likely drive a downwards revision to its growth and inflation forecasts and an upwards revision to its unemployment forecasts. So while the RBA has not been too fussed with the house price falls to date, its signalling that it will get a lot more concerned (read rate cuts) if (as we expect) house prices continue to fall.

• The Australian December half earnings reporting season has been better than feared but shows a slowdown in underlying growth, caution regarding the domestic outlook but an overall upgrade in earnings growth expectations thanks to resources stocks. 75% of companies have now reported. 56% of companies have seen their share price outperform on the day of reporting (which is above a longer term norm of 54%) but against this only 40% have surprised analyst expectations on the upside which is below the long run average of 44%, 34% have surprised on the downside which is above the long run average of 25%, the proportion of companies seeing profits up from a year ago has fallen and only 59% have raised their dividends which is a sign of reduced confidence in the outlook – six months ago it was running at 77%. Concern remains most intense around the housing downturn and consumer spending. While 2018-19 consensus earnings growth expectations for this financial year have slipped to 1% for the market excluding resources they have been upgraded to 14% for resources stocks as the higher iron ore price gets factored in. So earnings growth expecations for the market as a whole have been revised up to 5% from 4.3% a month ago. While several cashed up companies announced higher dividends ahead of Labor’s proposed franking credit cutback, overall dividend upgrades have fallen.
  
  

What to watch over the next week?

• In the US, expect a bounce back in January retail sales (Monday) after their aberrant December slump, a similar bounce in February consumer confidence, continued modest gains in home prices but a slight fall in January housing starts (all due Tuesday), December quarter GDP growth (Thursday) to show a slowdown to 2% annualised growth and the February manufacturing conditions ISM index (Friday) to slow to around 56. The core private consumption measure of inflation for December (also due Friday) is expected to remain unchanged at 1.9% year on year. Meanwhile Congressional testimony by Fed Chair Powell on Wednesday is likely to confirm that the Fed remains patiently on hold regarding interest rates and flexible regarding its quantitative tightening program.

• Eurozone data is expected to show unemployment remaining unchanged at 7.9% in January and core inflation for February (both due Friday) remaining around 1.1%yoy. Economic confidence data for February is due Thursday.

• Japanese industrial production data for January (Thursday) is expected rise slightly and labour market data (Friday) is expected to remain strong helped by the declining workforce.

• Chinese business conditions PMIs for February (due Thursday and Friday) are expected to show continuing softness in manufacturing but solid services sector conditions.

• In Australia, December quarter construction data (Wednesday) is expected to show a 0.7% gain, December quarter private investment data (Thursday) is expected to rise 0.8% with capex intentions also improving slightly, credit growth (also Thursday) is likely to have remained moderate in January and CoreLogic house price data for February (Friday) is expected to show a further decline.

• The Australian December half earnings results season will conclude with 43 major companies reporting including Boral (AX:BLD), Lend Lease (AX:LLC) and QBE (AX:QBE) (Monday), Caltex (AX:CTX) (Tuesday), Rio Tinto (AX:RIO) and Seek (AX:SEK) (Wednesday), and Ramsay Health Care (AX:RHC) (Thursday).

Outlook for investment markets

• Shares are likely to see volatility remain high with a high risk of a short term pull back, but valuations are okay, and reasonable growth and profits should support decent gains through 2019 as a whole helped by more policy stimulus in China and Europe and the Fed pausing.

• Low yields are likely to see low returns from bonds, but they continue to provide an excellent portfolio diversifier.

• Unlisted commercial property and infrastructure are likely to see a slowing in returns over the year ahead. This is likely to be particularly the case for Australian retail property.

• National capital city house prices are expected to fall another 5-10% this year led again by 15% or so price falls in Sydney and Melbourne on the back of tight credit, rising supply, reduced foreign demand, price falls feeding on themselves and uncertainty around the impact of tax changes under a Labor Government.

• Cash and bank deposits are likely to provide poor returns as the RBA cuts the official cash rate to 1% by end 2019.

• The Australian dollar is likely to fall into the $US0.60s as the gap between the RBA’s cash rate and the US Fed Funds rate will likely push further into negative territory as the RBA moves to cut rates. Being short the Australian dollar remains a good hedge against things going wrong globally.

I hope your weekend is on top of the world.