31 March 2017
Themes For March
Despite widespread predictions of a correction, financial markets were remarkably resilient in March with most major exchanges either flat or posting modest gains. The Australian share market finished 3.3% higher propelled by the major banks +4% which benefited from out of cycle interest rate rises, with other stand out sectors being Utilities +6.3% and Health Care +5.6%. Softer commodities prices saw the materials sector flat, however the energy sector posted a healthy 4.3% rise. European markets shrugged off electoral uncertainty to advance higher with Germany +2.4% and France +2.6% while the UK was flat in the wake of the formal filing of papers to exit the EU. The US market also finished flat despite a slew of negative political news led by the failure of President Trump to pass legislation through the Republican controlled congress to replace the ailing Affordable Care Act. The USD was weaker against EUR and JPY and flat against the AUD. Commodities took a breather from their recent stellar run headlined by a 12% fall in iron ore, while crude oil was 5% lower. Bond markets were stable with the US bond market taking the largely telegraphed 0.25% hike in the Fed Funds rate in its stride.  

Sydney and Melbourne property prices present a policy conundrum

Rampaging property prices in Sydney and Melbourne have now become both a political issue, with respect to housing affordability, and a vexing policy issue for both the RBA and APRA who are rightly concerned about the broader economic implications of an emerging asset price bubble. In the past 5 years, residential property prices have risen by 75% in Sydney and by 50% in Melbourne, way in excess of other capital cities such as Perth where prices have actually fallen substantially in the aftermath of the mining boom.

capital city

Demand in our two largest cities has been fueled by strong population growth, cheap and easy availability of credit together with tax incentives for investment properties. On the supply side, there has been a limited response (other than in the inner city apartment market) partly due to inadequate infrastructure spending. RBA Governor Philip Lowe made reference to tax policy being a key contributor to property demand, referring in particular to negative gearing and the CGT discount for investment properties held for more than 12 months. Expect a policy response from the Federal Government in the upcoming May Budget on these taxation issues, as housing affordability for first homebuyers is fast becoming a major political issue at both State and Federal level. Governor Lowe also expressed concern about the sharp rise in the leverage of household balance sheets leaving households exposed to any significant future increase in interest rates. APRA is also closely monitoring the capital adequacy of our banks to assess their ability to absorb the impact of a meaningful downturn in property prices.

It is highly unlikely the RBA will increase official cash rates as a means of cooling the over heated property markets in Sydney and Melbourne. As mentioned in previous months, monetary policy is a very blunt instrument and raising rates now would have disastrous consequences for the nascent “green shoots” economic recovery that is underway. The RBA are rightly concerned that employment growth, retail trade and business investment are still too fragile to handle a rate rise, especially when inflation is still below the bottom end of their target range. In a way, the major banks are doing the bidding for the RBA by introducing off-cycle rate rises for certain loans. Late in the month, APRA announced long overdue macro prudential measures, focused on a 30% limit on interest only loans (from current levels of around 40%), placing greater scrutiny on high loan to valuation lending and applying stricter debt serviceability tests. Somewhat surprisingly, the 10% cap on investment loans was not reduced as expected although a many of these loans are interest only so would be caught by the broader restriction on these types of loans.


tightening lending

Politics still driving markets in the US, Europe and the UK

The Trump “reflation trade” is a commonly used term to describe the pro-growth policies of the new administration focused on tax cuts, infrastructure spending and regulatory reform. These factors have been the dominant influence in the US, and indeed global financial markets, since the US Presidential election in November 2016. The failure of the Republican controlled congress to pass legislation to repeal and replace the Affordable Care Act has thrown into question whether President Trump will be able to sign into law the market friendly pro-growth policies. Tax cuts have been a key tenet of conservative US politics since the Reagan administration in the 1980’s, however the negative budgetary impact of these in concert with a proposed $1 trillion government infrastructure spending program will no doubt raise the ire of hard line fiscal conservatives within the Republican Party. Any delay or dilution of the proposed tax cuts which calls for a reduction in the corporate tax rate from 30% to just 15% will be adversely received by the US share market.

Recent elections and polls in Europe have been a blow for populist candidates that tend to favor more nationalist policies such as the withdrawal from the EU and strict immigration controls. In the Netherlands, populist candidate Geert Wilders garnered only 13% support translating a minority position of 20 seats in their recent general election. In France, right wing candidate Marine Le Pen is sliding in the polls and now appears to have little chance of success in the second round run-off election to be held on May 7th likely to be against the more centrist candidate Emmanuel Macron. These political developments are positive for European markets already buoyed by record low interest rates together with the continuing EUR 80 billion per month QE program run by the ECB.

UK Prime Minister Theresa May has now formally lodged notification under article 50 of the Lisbon treaty to exit the EU, which commences a 2 year divorce process. This will cast a long shadow over the UK economy with key negotiations concerning trade and the mobility of labor between the UK and the Continent, likely to take some time to resolve. In response to this, Scottish Minister Nicola Sturgeon, has now called for a second referendum on Scottish independence, to resolve the question as to whether they remain attached to the EU in preference to remaining part of the UK.

Investment Outlook

The resilience of share markets over the past month has surprised us but served to strengthen our conviction that the market is overdue for a correction which arguably may be a necessary pre-condition for further longer term advancement from here. A lot of good news is factored into current valuations and with sentiment at buoyant levels, markets remain vulnerable to any bad news. Taking a longer-term view, we remain constructive on the outlook for equities as the global economic environment continues to improve and conversely, we are bearish on the outlook for government bonds as inflation gradually rises and the process of interest rate normalisation continues.