Themes For January

31 January 2017

Markets started the New Year on firm footing with equities in most countries posting modest gains in January. The US market finished 2% higher on continued optimism that President Trump’s pro-growth policies will stimulate the economy and boost corporate profits. In other major markets, Germany was up 1.8%, Hong Kong powered ahead by 6.2% and China improved 1.8% following the release of its December quarter GDP showing annual growth of 6.8%, marginally better than expected. The Australian market was slightly softer by 0.8% with weakness in industrials offset by the burgeoning resource sector boosted by strong bulk commodity and energy prices. The UK was also marginally weaker by 0.6% as the UK High Court ruled that Parliament must approve the decision to exit the EU before article 50 of the Lisbon treaty can triggered to commence the withdrawal process.

Bond markets were fairly subdued with Australian 10 year bonds 5bp firmer to close at 2.71% while US 10 year bond yields finished up just 1.6bp to 2.46%. Amongst the major commodities, iron ore was up 4.4% to continue its stellar run in 2016, copper was up 5.2%, while oil fell 2% after its strong advance last year. The AUD was 4.4% stronger against a weaker USD, which declined on most major crosses on profit taking following its surge in late 2016.

The jury is out on the next move in Australian interest rates

Australia’s official cash rate of 1.5% is amongst the highest in the developed world. By comparison, the US Fed maintains a cash rate in the range of 0.5-0.75% despite its economy appearing to be stronger than ours. Both the Australian Government and RBA received a wake up call when the National Accounts for the September quarter showed a contraction in GDP, raising the possibility of a technical recession, defined as two consecutive quarters of negative GDP growth. The positive interest rate differential in Australia’s favour is one of the major reasons the AUD has been so strong of late as capital inflows have been attracted by yield hungry foreign investors. A strong AUD has much the same effect on the economy as higher interest rates due to its negative impact on the tradable goods sector. There’s no doubt the RBA would like to see the AUD lower than its current level of US 75.6 cents to obviate the need for further rate cuts.

While the RBA has cut cash rates several times since the GFC, the strength of our mining sector over this period prevented the need to reduce rates to the same extent as other countries. With the post commodities boom run-off in mining investment, the RBA is now relying on other sectors of the economy such as housing, consumer spending, tourism and business investment to pick up the slack. The problem with monetary policy is that it is a blunt instrument and can’t be used to fine tune specific segments of the economy. While business investment would certainly benefit from a further rate cut, the RBA is cognisant of buoyant housing markets in Sydney and Melbourne and is cautious about creating an asset price bubble in these markets. To prevent this occurring it would prefer to see a further tightening of prudential lending standards by APRA to mitigate the growth in lending to the housing sector.

The CPI release for the December quarter showed that underlying inflation rose 1.6% for the year, still below the lower end of the RBA’s 2-3% target band for this measure. While you could argue that we have seen the bottom of the inflation cycle, there is plenty of room to cut rates from here if the economy needs a kick along. Further strength in the AUD towards US80c may well force the RBA’s hand as will any pre-emptive move by banks to raise home loan rates in the same manner as they have done for some investment loans. We still expect at least one further cut in cash rates this year although not before May, and dependent on the flow of data in coming months.

Storm clouds gathering over Europe

While investor sentiment is bullish in the US in the wake of the Presidential election, the mood of investors is beginning to sour in Europe. While it is clear that the process of the UK exiting the EU will be a long and protracted process over the next 2 years, the stability of the EU faces additional challenges from other Continental member countries. The first test will come from the French Presidential election in April where Marine Le Pen, the leader of the right wing National Front party, currently leads in the polls. She is advocating for a more isolationist France that would withdraw from the Eurozone, re-install the franc as the national currency, hold a Brexit style referendum on EU membership and impose strict immigration controls. There is a two stage electoral process in France with a first round election to be held in April following which the top 2 candidates face each other in a run-off election on May 7th to decide the new President. While Le Pen is not expected to win the second round ballot, a recent scandal involving a major rival Francoise Fillon, has boosted her prospects of victory. At this stage the moderate candidate Emmanuel Macron is the favourite, however Brexit and the US election have cautioned us to not rely too heavily on opinion polls!

This is all playing out against a backdrop of better economic data in Europe with leading indicators of economic activity such as the manufacturing Purchasing Manager’s Index (PMI) recently improving to a 67 month high. In addition to this the ECB has reaffirmed that it will continue to provide monetary stimulus via quantitative easing at the rate of EUR 80 billion per month until April 2017, scaling back to EUR 60 billion by December 2017. Corporate profit expectations in Europe are also improving with superior upgrades compared to most other global markets.

Investment Outlook

As mentioned last month we expect a consolidation or mild correction in equity markets at some stage in the next few months. The strong advance since November 2016 has largely been on the back of positive sentiment which underestimates the significant hurdles ahead to implement the pro-growth policies the market has warmed to. Looking further out over a 12 month time period however, we still remain constructive on the outlook for equities and conversely negative on the prospects for defensive assets such as government bonds. While strengthening economic growth will produce slightly higher inflation and interest rates, it will also boost corporate profits especially in the US where large corporate tax cuts are soon to be announced. It remains our intention to use any near term market correction to build equity positions to benefit from the improving longer-term outlook for global share markets.