28 July 2017
Themes For July
Equities continued their advance in the first month of the new financial year with most markets posting positive returns for the month. Positive construction data out of China saw Hong Kong advance by 6.1% while mainland Chinese shares improved 2.5% for the month. Despite on-going political turmoil in the US, the S&P500 advanced a solid 2.1% on the back of solid earnings results while UK and European shares posted small gains for the month. The Australian market was essentially flat with a strong 11% rise in the iron price boosting mining shares offset by weakness in the healthcare sector (due to a stronger AUD) and the interest rate sensitive utilities and telco sectors. The oil price had a nice 12% bounce reversing the losses from the previous month on the back of a decline in US stockpiles rather than any meaningful improvement in demand. Australian 10 year bonds were flat for the month finishing at 2.68% while the RBA left the official cash rate unchanged at 1.5%.   Global currency moves were a prominent feature of the investment landscape with a weaker USD the central theme especially against the EUR and AUD, with the local unit touching a high of 80 cents.

The Global Economy continues to improve

In previous years, the IMF has consistently revised down its global growth forecasts throughout the calendar year. Following its latest review however, the IMF maintained its growth forecast of 3.5% for 2017 and 3.6% for 2018, a vote of confidence that the gradual recovery that has been in train for some time now is beginning to gain traction.

IMF Global

Despite concerns the US economy was losing steam, data released over the month confirmed the recovery in the world’s major economy is still on track. March quarter GDP printed at a solid 2.6% while inflationary pressures remained subdued at just 1.5%. The July employment result showed a better than expected 209,000 new jobs, with the previous month revised higher also. Wages growth is showing some sign of improvement rising by 2.5% over the past year which points to some upward pressure for inflation. The strong labor market highlighted by an unemployment rate of just 4.3%, gives the US Fed every justification to continue its process of reducing its accommodating monetary stance. The process they will follow will be to firstly commence the process of running off its balance sheet holdings of bonds and mortgage backed securities (a form of reverse QE), followed by a further 0.25% increase in the cash rate in December.

US Average

Source: US Department of Labor

The US economy is providing a solid backdrop for stronger US corporate profits with June quarter US earnings expected to deliver 12% growth over the past year, under-pinning share valuations at current levels. So far around 85% of S&P 500 companies have reported with 77% exceeding expectations and importantly 68% beating top line revenue expectations. Critical to continuing the momentum in the US share market is the delivery of tax reform, including substantial corporate and personal tax cuts to further stimulate the US economy. With the failure of the Republican controlled Congress to pass legislation to reform and replace the Affordable Care Act (better known as Obamacare), political pundits are casting doubt about the ability of Congress to pass a tax reform plan. With mid-term elections to be held in November 2018, it is absolutely critical that Republicans get some runs on the board by delivering this key pillar of President Trump’s election platform. While there will be some debate amongst the fiscally conservative “Freedom Caucus” of the Republican Party on the need for spending offsets to keep the deficit under control, self-interest is a great motivator, so we are confident that a significant tax cut will be delivered by Q1 2018 at the latest.

RBA kicks an own goal for the AUD and the economy

Early in the month, the RBA released the minutes from its last meeting, which included a comment suggesting a neutral cash rate of 3.5%, implying eight 0.25% hikes lie ahead. This sparked frenzied buying of the AUD as it was speculated by currency markets that the RBA had moved into tightening mode commencing as early as November, in sharp contrast to the previously stated neutral stance. A stronger AUD is unequivocally bad for the Australian economy due to its negative impact on exports and key import competing industries such as tourism and education. A 10% rise in the AUD on a TWI basis would cut between 0.5%-1% off GDP over a 2-year period. It is akin to a tightening in monetary conditions due to the deflationary impact via lower import prices, which is likely to further delay any potential rate hike. It is hard to fathom why the RBA would comment on this as the “neutral rate” is essentially a theoretical academic concept and was always going to lead to speculative AUD buying. Quickly moving into damage control, speeches by RBA Governor Philip Lowe and Deputy Governor Guy Debelle hosed down speculation of an imminent rate hike and re-enforced their neutral policy stance and emphasised that Australia did not have to move in lock step with overseas rate rises. The release of the March quarter CPI showed underlying inflation of just 1.8%, below the lower end of the RBA’s band obviating the need for tighter policy.

Investment Outlook

Financial data released over the month has reinforced our assessment of investment markets and confirmed our current strategy stance. In setting our investment strategy, we take a medium term view on the direction of financial markets, which tends to be fairly stable month to month. Our strategy is predicated on the belief that equities are likely to provide the best returns over the next 12 months with international shares (especially Europe) expected to do better than Australian shares. Defensive assets such as government bonds, fixed term and cash accounts will offer good security but poor returns especially after tax and inflation. Despite its recent strong run, the AUD is likely to trend lower over the next year driven by the reality of a narrowing interest rate differential with the US.