5 January 2018
While share markets saw a softish last few days of 2017, they have started 2018 on a solid note with strong gains in all major markets over the last week helped by favourable economic data and as seasonal cheer kicked in again. US shares rose 2.6% to a new record high, Eurozone shares rose 3%, Japanese shares rose 4.2%, Chinese shares rose 2.7% and the Australian S&P/ASX 200 Index rose 0.9%, taking it above 6,100 for the first time in ten years. Bond yields have also pushed slightly higher over the last week as have prices for oil, gold and iron ore. The combination of further weakness in the US$ and rising commodity prices has seen the Australian dollar push higher.
Are global economic conditions so good that they are bad? We are continuing to see record or near record highs in various business and consumer confidence readings globally. A concern is that historically it doesn’t get much better than this and we saw how similar readings around 1999-2000 & 2006-2007 ended badly. The big difference this time compared to those periods of similar highs in confidence readings is that at those peaks inflation was becoming more of an issue and global monetary policy was tight and bearing down on growth, whereas now inflation is still low and monetary policy remains easy. In other words, we are still in the “sweet spot” in the investment cycle, which augurs well for further gains in growth assets, albeit share market volatility is likely to rise and returns are likely to be more constrained this year as inflation starts to rise in the US and geopolitical risks become a focus again.
Major global economic events and implications
US data over the last two weeks has remained strong with robust readings for business conditions including the ISM business conditions indexes, construction activity, labour market indicators, pending home sales and home prices. Consumer confidence fell in December but to a level that is still high. While payroll growth in December of 148,000 was less than expected, it has averaged 176,000 over the last six months, which is well above the 100,000 necessary for a stable unemployment rate. A wider than expected trade deficit indicates that trade will likely be a constraint on December quarter GDP growth though. Meanwhile, the minutes from the US Federal Reserve’s (US Fed) December meeting indicate that it’s not too concerned about currently low inflation and the flatter yield curve and remains upbeat on growth helped by tax cuts, which is all consistent with ongoing gradual monetary tightening this year. While wages growth remained softish at 2.5% year-on-year in December, we remain of the view that the US Fed will hike rates four times this year as growth is strong and eventually inflation lifts with the first move in March, in contrast to market expectations for just two hikes. This should eventually turn the US$ higher and put further upwards pressure on bond yields.
Eurozone inflation remained low in December with core inflation stuck at 0.9% year-on-year, which is consistent with the European Central Bank continuing to slow stimulus very gradually despite good growth.
Japanese data points to continued reasonable growth in Japan with solid business conditions PMIs, gains in industrial production and household spending and a continuing tight labour market. Even core CPI inflation rose in November, but only to 0.3% year-on-year, so it’s still premature for the Bank of Japan to start thinking about exiting ultra-easy monetary policy.
Chinese business conditions PMIs were mixed for December but on average were solid, whereas industrial profits slowed in November. The overall impression is that growth may have slowed a bit in the December quarter from 6.8% year-on-year in the September quarter, but not by much.
India’s December manufacturing PMI climbed to its highest in over five years and its services PMI improved, pointing to strengthening growth, after the hits from demonetization and the GST start-up.
Australian economic events and implications
In Australia, home prices softened further in December as the Sydney and Melbourne property boom continues to deflate. Tighter lending standards, rising levels of unit supply, slower Chinese demand and reduced investor enthusiasm for property are all impacting and are likely to lead to further declines in Sydney and Melbourne property prices this year of around 5% – maybe a bit more in Sydney and a bit less in Melbourne. The cooling in the Sydney and Melbourne markets is good news for APRA and the RBA and helps provide the necessary flexibility to leave interest rates low until the broad economy is ready for a hike (which we don’t expect to be the case until late this year). It also provides a bit more room for first home buyers. However, other cities are running to their own cycles, with Hobart likely to continue strengthening, Perth and Darwin close to the bottom and moderate growth in Adelaide, Brisbane and Canberra.
What to watch over the next week?
In the US, the main focus will likely be on December retail sales (due Friday) which is likely to show another solid gain buoyed by strong jobs growth and consumer confidence. Job openings and small business confidence (both Tuesday) are also likely to remain strong. Meanwhile, core CPI inflation for December (Friday) is likely to remain below target at around 1.7% year-on-year.
Eurozone economic confidence data for December (Monday) is likely to remain very strong and the unemployment rate (Tuesday) is likely to show a further fall to 8.7%.
Chinese trade data (Friday) for December is likely to show continuing strength, but export growth slowing slightly to around 11% year-on-year and imports slowing to around 14% year-on-year.
In Australia, expect November building approvals (Tuesday) to show a 1% fall, ANZ job ads (also Tuesday) and ABS job vacancies data (Wednesday) to remain strong and November retail sales data (Thursday) to show a 0.1% gain.
Outlook for markets
For 2018, continuing strong economic and earnings growth and still easy monetary policy should keep overall investment returns favourable but stirring US inflation, the drip-feed of US Fed rate hikes and a possible increase in political risk are likely to constrain returns and increase volatility after the relative calm of 2017.
Apart from the likelihood of more volatility through the year, global shares are likely to trend higher through 2018 and we favour Europe (which remains very cheap) and Japan over the US, which is likely to be constrained by tighter monetary policy and eventually a rising US dollar. We favour global banks and industrials over tech stocks that have had a huge run.
Emerging markets are likely to underperform if the US$ rises as we expect.
Australian shares are likely to do okay but with returns constrained to around 8% with moderate earnings growth. Expect the S&P/ASX 200 Index to reach 6,300 by end 2018.
Commodity prices are likely to push higher in response to strong global growth.
Low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds.
Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors.
National capital city residential property price gains are expected to slow to around zero as the air comes 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 a short term further bounce higher, the A$ is likely to fall to around US$0.70, but with little change against the Yen and the Euro, as the gap between the US Fed Funds rate and the RBA’s cash rate goes negative. Solid commodity prices will provide a floor for the A$ though.