Markets have been fuelled by a decade of bailouts and dovish monetary policy. It’s hard to ignore the importance of this fact and how it has characterised the current economic expansion. Just recently the Federal Reserve has cut its main interest rate by 25 basis points, the first reduction since the financial crisis, and signalled that it was prepared to ease monetary policy further if necessary. In its policy statement, the US central bank suggested the monetary easing was justified by “uncertainties” stemming from weakness in the global economy and simmering trade tensions. Adjusted for inflation, the Fed’s benchmark rate is now just a quarter of a percent and the cost of borrowing has rarely been closer to free, but the dependency for easy money keeps growing. With trade wars threatening the global economy, Federal Reserve officials say rate cuts are needed to keep the slowdown from spilling into the United States, and to prevent doggedly low inflation.
Wage growth is also preoccupying policymakers. Last year, Mr Powell and other Fed officials assumed that wages would pick up as the US economy barrelled towards full employment, feeding through to higher prices and inflation. This dynamic would be the trigger for rate rises. But it did not turn out that way. Now Mr Powell launched a review of the Fed’s policy framework, and changes to the way officials look at inflation rose quickly up the agenda.
Many Western economies are facing a similar ominous backdrop following the global financial crisis of 2008. Since then central banks have responded aggressively to every hint of a downturn, making money ever cheaper and more plentiful to try to juice growth. Yet, in this expansion, the United States economy has grown at half the pace of the post-war recoveries and inflation has failed to rise to the Fed’s target of a sustained 2 percent. Meanwhile, every new hint of easy money inspires fresh optimism in the financial markets, which have swollen to three times the size of the real economy.
Trade negotiations on twitter
US President Donald Trump said the US would place a 10 per cent tariff on $300bn of additional Chinese goods, escalating the trade war between Washington and Beijing in a new threat to the global economic outlook. The announcement shook financial markets, sending the yield on the 10-year Treasury note to its lowest level since 2016 and pushing down stock prices after they had risen earlier in the day.
In a series of afternoon tweets, Mr Trump shattered a tenuous truce he reached with Xi Jinping, his Chinese counterpart, at the G20 summit in Osaka in late June, which had paved the way for a new round of high-level upcoming talks in Shanghai. The truce with Xi Jinping temporarily suspended his threatened imposition of duties of up to 25% on $325bn-worth of Chinese imports, but leaves in place all previous tariffs imposed during the trade war. Trump also threatened in May to impose tariffs on all imports from Mexico if it did not crack down on immigration but reversed himself in June. He has delayed till November a decision on whether to impose tariffs on automobile imports, which would hit European manufacturers hard.
Global trade growth has fallen from 5.5% in 2017 to 2.1% this year, by the OECD’s reckoning. The immediate threat comes from President Donald Trump’s imposition of tariffs on America’s trading partners and renegotiation of free-trade agreements, which have disrupted long-standing supply chains in North America and Asia.
Slowing, but resilient US GDP
In the US there have been some signs of a slowdown, with second-quarter growth coming in at 2.1 per cent, a big drop compared to 3.1 per cent in the first quarter and a far cry from Trumps 3%.
However, the gross domestic product figures topped Wall Street’s median forecast. Strong consumer spending helped sustain the expansion even as businesses cut back on investment. The GDP showed substantial softness in business investment but other parts of the economy are holding up. Consumption remains strong, as is the labour market which experienced solid employment growth in June.
Brexit uncertain is a certainty
Britain now has its third Tory prime minister since the vote to leave the European Union three years ago. Its deadlocked Parliament is refusing to back the exit deal struck with the EU, even as an October 31st deadline approaches. The uncertainty is quickly reflected in the pound, which is near an all-time low against the US and wilting at the prospect of crashing out with no deal. Steering a course out of this mess requires an extraordinarily deft political touch. Boris Johnson, socially liberal, pro-immigration but more recently turned Eurosceptic, has been chosen for the tall order.
Mr Johnson may be making similar mistakes as his predecessor Mrs May. Her undoing was through making unrealistic promises about the deal Britain would get, pledges she spent two dejected years retreating from. Boris promises he will bin the “backstop” designed to avoid a hard border in Ireland, which the EU insists is non-negotiable. He claims Britain need not pay the exit bill it agreed on and he says that if the EU does not roll over, it would be “vanishingly inexpensive” for Britain to leave with no deal. Mrs May found the contact with reality hard enough, for Mr Johnson it could be brutal.
Getting the support of parliament is an additional complication for Mr Johnson. The Conservatives’ hold a narrow majority, with plenty of rebels on both the Brexit and Remain wings. So, doing a deal would probably mean working with Labour, whose price is a second referendum and unlikely to be acceptable to hard-line conservatives. In the Brexit saga uncertain is a certainty.
Australia regionally positive
Since the Federal election saw the unexpected return of the centre-right Liberal/National coalition government there has been a period of stabilisation in Sydney and Melbourne property markets. The election result removed the prospect of significant changes to taxation arrangements for property investors which could partly explain the modest recovery that the recent house sales volumes and numbers suggest.
Summary
Familiar triggers for recession are still absent which suggests that the (moderately) good times can roll on. The trouble with this logic is that, just as the economy has changed, so have the risks and it is inevitably hard to identify exactly what might go wrong. Dependency of growth on monetary policy cannot be sustained indefinitely and political risks such as Brexit and US China trade tensions remain on the horizon with potentially disastrous consequence.
The good news: households and firms in developed markets can borrow at exceptionally low rates, unemployment is low, labour income continues to grow, and business cost pressures are visible but modest.
A balanced and diversified approach to investment remains appropriate.
Last month we wrote about the significance of the dovish positioning from the central banks around the world led by the Fed backing off interest rate increases earlier in the year. This response from central banks worked to support markets and was essential to offset investors’ concerns around slowing global growth. The relationship between slower growth and low interest rates remains a central theme to the global economy and is a key consideration for investors.
There were some positives in April to restore some confidence that a slowdown in global growth was previously overstated by some commentators. Trade flows are picking up in Asia, America’s retail sales have been strong and even Europe’s beleaguered manufacturing industry has shown flickers of life. Also positive, albeit retrospective, was the news that the US delivered beyond market expectations for first quarter 2019 GDP growth, while defying claims of a possible earnings recession.
However, it would not take much bad news to reinstate caution. The global economy has slowed and further downwards momentum, or a new negative shock, could further weaken economic prospects. Policy risks in the form of deteriorating US-China trade relations and a No-Deal Brexit remain key threats too.
US – Economy boasts +3.2%… but still no inflation
The US economy defied fears of a first-quarter slowdown, overcoming a prolonged government shutdown, trade tensions and global economic uncertainty to deliver growth that trounced analysts’ expectations. Gross domestic product rose at an annualised pace of 3.2 per cent during the first three months of the year, handily topping Wall Street predictions for 2.3 per cent growth. It is also an improvement from the 2.2 per cent pace of expansion recorded during the fourth quarter of 2018. The robust reading is a boost for economies around the world after a growth scare earlier this year triggered a fall in bond yield.
The data quelled previous fears that the US is running into an imminent recession and leaves the economy on track to hit its longest-ever expansion later this year. But beneath the impressive headline growth figure, some of the underlying detail in the report was less buoyant. Consumer spending slowed from the fourth quarter and growth relied heavily on a build-up in inventories, which could reverse later this year. The report will further complicate the policy deliberations at the Federal Reserve, which is weighing firm headline growth and a resilient labour market against perplexingly soft inflation as it considers whether the next move in rates should be down rather than up.
The US central bank, led by chairman Jay Powell, is likely to keep policy unchanged at 2.25 to 2.5 per cent for the more immediate future. With US activity improving after a shaky start to the year and overseas risks diminishing, many commentators suggest the Fed will likely keep rates at their current level for the remainder of the year.
US-China trade negotiations – high hurdles remain
As U.S. and Chinese officials try to close a trade deal, the punitive tariffs the governments slapped on each country’s goods in the conflict stand as a major obstacle. High-level talks between the U.S. and China recently resumed in Beijing. As they work through final issues, including planned Chinese purchases of U.S. goods, how and whether to remove the tariffs the two governments imposed in the earliest phases of the dispute are now at the forefront of the talks. At issue is how much of the tariffs the U.S. levied on $250 billion of Chinese goods will be removed. The U.S. wants to leave some in place as a tool to enforce the agreement while Chinese negotiators see those tariffs as an affront, and negotiators have batted the issue back and forth for at least a month.
One can be confident Beijing won’t want to accept a deal where the U.S. continues to insist on imposing tariffs, and prohibits China from retaliating, as a way to make sure Beijing fulfils commitments in a trade deal. The tariffs would be embarrassing for the leadership and politically difficult to sell to Chinese businesses and other domestic constituencies. The current tariffs also created uncertainty for investors, compounding last year’s slowdown in the Chinese economy.
Europe – Some green shoots
In March this year, the narrative surrounding the euro region was driven by fears of ‘Japanification’ (describing the environment of deflation and expansionary monetary policy such as experienced in Japan). The manufacturing Purchasing Managers’ Index (PMI) for the region had declined, despite a rise in PMIs around the world. At the same time, the European Central Bank extended their forward guidance for the period in which rates will remain negative to the end of the year, raising the prospect of a negative rate trap (where target interest rates are set below zero) for the region and its banks. Just one month later the macro view of Europe is turning more positive. Business confidence is still low but has recently posted its first increase in six months and retail spending has improved, supporting the case that strong labour markets will continue to support household spending. However more generally, across Europe confidence continues to wane across all sectors, which suggests activity indicators will continue to print on the soft side and interest rates will remain low for the foreseeable future.
UK – Kick Brexit down the road
In our April economic report, we wrote about the chaos created by Brexit and apparent lack of a clear and viable way through. Since then not much has changed except to provide for more time (31 October is the third ‘final’ deadline). Mrs May asked the EU for more time because MPs voted down her exit deal three times. Getting the House of Commons’ bipartisan approval for the draft treaty is still a big challenge, unless the talks between the Conservatives and Labour produce a breakthrough. But the Prime Minister is wishful that the deal can be approved and ratified before May 23, so Britain can avoid holding elections to the European Parliament that day.
In a blow to the chances of a second referendum, Jeremy Corbyn has seen off a challenge from Labour’s Europhile wing, defeating a bid to commit the party to holding a second EU referendum in all circumstances. The Labour leader announced afterwards that the party would maintain its existing policy of backing a soft Brexit with a customs union. He added that Labour would support the “option” of a public vote only if it was unable to secure the changes to the government’s existing withdrawal deal and could not force a general election.
Australia – Location, Location, Location
Across the Tasman, Australian economic growth remains constrained as the housing market in Sydney and Melbourne continues to negatively impact consumer spending and housing construction. The labour market is holding up well, but the softening in the housing market is expected to hit jobs related to construction, housing services and retail, and cause a rise in the unemployment rate. Business investment growth is improving as mining investment is no longer acting as a large drag on the economy, but non-mining business investment remain underwhelming.
Sydney’s median house price will fall below $1 million within the next two months even if the property downturn eases slightly from its current pace. Sydney house prices have now fallen 14.3 per cent from their mid-2017 peak, including a drop of 3.1 per cent over the March quarter. Melbourne house prices fell 10.4 per cent over the year and 2.4 per cent over the quarter.
An election later this month is likely to see a new Labour-led coalition. This has the potential to bring some policies which are business unfriendly.
New Zealand – following the herd
New Zealand GDP growth, emblematic of the global economy, shifted down a gear as the data for second half of 2018 was disappointing, and rising capacity constraints will continue to have a moderating influence on growth in activity. There are tailwinds, largely on the back of fiscal stimulus and growth in labour income.
According to the ANZ Business Outlook Survey, business confidence and firms’ own activity outlook were little changed in April with both remaining at levels well below their long run average (47pts below and 20pts below respectively). Capacity utilization fell to a new post-GFC low. The RBNZ signalled a material dovish pivot at its April meeting part of which highlighted concerns around a slowdown and ongoing weak business surveys. There is little in the ANZ survey to allay the RBNZ’s concerns on the latter. The RBNZ decided to cut the OCR by 25bp at its May meeting.
Summary
We are cautiously positive on equities because economies around the world are still expanding at decent rates and there are no apparent inflation trends. While there are risks that could push the markets periodically downwards, we believe that last year’s bearish moves restored some value to the markets and interest rates now look to be heading lower, not higher.
We believe that maintaining your long-term neutral asset allocation continues to be appropriate in light of the environment.
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Information and Disclaimer:
Source:JMI (previously JMIS), the investment consultant to the Select Wealth Management service.
This report is for information purposes only. It does not take into account your investment needs or personal circumstances and so is not intended to be viewed as investment or financial advice. Should you require financial advice you should contact Miles Flower on 021 645 000.
Globally, the Fed and US-China trade relations continue to take centre stage in the economic theatre of 2018 (so far a drama not a tragedy) while Brexit and Italy present challenges to the European outlook.
US / China Trade
In a much-anticipated working dinner in Buenos Aires following the G20 summit, Mr Trump and Mr Xi agreed to a temporary ceasefire, in which the US president suspended his decision to impose higher tariffs, from 10% to 25% on $200bn on Chinese imports until March 1st, 2019 at the earliest. In exchange, China will increase its purchase of American farm produce, energy and some industrial goods. However the truce is fragile and formal talks between the two countries could well fail due to the high hurdles that stand in the way of agreement. First, the Chinese commitment to raise purchases of American goods is by an amount “not yet agreed upon, but very substantial” is unlikely to reduce America’s bilateral trade deficit with China by a significant amount. Second, the challenge that negotiators now have 90 days to agree “structural changes with respect to forced technology transfer, intellectual property protection, non-tariff barriers, cyber intrusions and cyber theft, services and agriculture” is ambitious, particularly when levels of trust between the two sides are so low. It is evident that this theme will continue into 2019.
China
China’s recent slowdown in gross domestic product growth is unsettling global markets and testing the Communist party leadership. Beijing is determined to keep its economy stable but doing so means tackling the politically sensitive issue of its private sector. Private enterprises are China’s economic mainstay, contributing about two-thirds of output and investment and the lion’s share of jobs. They drive the prosperity upon which the Communist party’s legitimacy rests. Yet Mr Xi has favoured state-owned firms since he took power in 2012 and clipped the wings of several high-flying private entrepreneurs. Now, as Beijing seeks to stiffen its resolve in the US-China trade war, the private sector’s dynamism is flagging, creating economic headwinds. Third-quarter GDP growth slipped to 6.5 per cent, year on year, its slowest since 2009. While this is by no means lacklustre, there are signs momentum could slackenfurther.
We expect flexible policy to come from Beijing as it attempts to manage headwinds associated with trade disputes, slowing demand and negative sentiment toward its equity markets causing investment outflows. China has accounted for 36% of global GDP growth since 2010 and has played a vital role in the economic recovery. This too will be a key focus for the global economic outlook in 2019.
Brexit
Political uncertainty in the UK is extreme currently and reflected in investor positioning in sterling and UK equities.
Theresa May is battling to save her Brexit deal and her own position as Prime Minister after a series of ministerial resignations and the threat of a Eurosceptic coup left the Conservative party on the brink of civil war. Mrs May insisted she would stick to her plan, which would keep Britain closely tied economically to the EU, and said she was not about to quit in spite of growing criticism from Brexiters in her own party. Mrs May warned that Britain would embark on “a path of deep and grave uncertainty” if it abandoned the withdrawal deal it had agreed with the EU.
It’s unclear whether the refusal of May’s deal by British parliament would turn into a ‘hard’ Brexit (i.e. with no deal). The crucial vote in Parliament is on December 11th. May said there was no plan B, however, some commentators suggest that the transition period may get extended again due to the complexities of reaching a deal. The more it is extended, the closer it gets to the June 2022 election, increasing the likelihood of a potential second referendum.
Britain’s Treasury estimated that GDP will be 3.9% smaller in 15 years’ time than it would otherwise have been if the country leaves the European Union under the deal recently agreed with EU leaders. Under a no-deal Brexit, it would be 9.3% smaller.
US
The Fed’s tightening path had fuelled fears about a sharp downturn in the US housing sector. Home sales have slowed, inventories are rising, and homebuilder equities have sold off over 30% YTD.
However, the recent market reaction to a statement from the Federal Reserve Chairman Jerome Powell that we are approaching neutral shows how critical investors see this current period of tightening. Sharemarkets rallied as Jerome Powell said he sees current interest rates “just below” neutral. That proved to be significant because the language Mr. Powell used 6 weeks earlier indicated a view that the fed funds rate was “a long way from neutral.” Powell added that there is no pre-set policy path, and the Fed will be data-dependent in its decision making, which pleased investors. By highlighting risks, though, that included previous rate increases, trade disputes, and Brexit/EU political uncertainty, the market chose to read between the lines that the Fed chair isn’t wedded to three rate hikes in 2019.
The results for the recent US midterm elections were widely predicted (which is a surprise by itself). Democrats took the House of Representatives which will provide some oversight of the White House when members of the new Congress take their seats in January. Republicans held the Senate—with a bigger majority, which will make presidential appointments easier to confirm. Both sides declared victory. A starkly divided country now has a divided government. Underpinning the results, though, is the deepening of a structural shift in American politics that will make the country harder to govern for the foreseeable future.
Europe
The fate of the euro strongly depends on Italy. With annual GDP of more than €1.6trn ($1.9trn), about 15% of euro-area output and debt of nearly €2.3trn, it poses a challenge to the single currency that Europe seems unable to manage but cannot avoid. Matters are now coming to a head, as Italy’s new coalition government instigates a showdown over the European Union’s fiscal rules. The disagreement might well become disastrous. But it is also an opportunity for the euro zone to begin building a better, more durable approach to fiscal policy.
Trouble began earlier this year when the populist Five Star movement, led by Luigi Di Maio, formed a government with the right-wing Northern League, led by Matteo Salvini. Both promised budget goodies: Mr Salvini a hefty tax cut and Mr Di Maio a basic minimum income. Such a bounty may test the deficit limit of 3% of GDP set by the EU’s stability and growth pact and it seems certain to break other fiscal rules set by the bloc: the government’s initial budget plan is forecast to raise borrowing to 2.4% of GDP in 2019, above the 0.8% target to which Italy previously committed itself and enough to reverse recent, modest declines in its debt burden.
The EU did not take the news well. On November 5th other countries’ finance ministers warned that failure to revise the budget would lead to an “excessive deficit procedure” and possible sanctions.
Australia
We expect real GDP growth of around 3% by end-2018. Such a pace of growth should see the unemployment rate largely track sideways over 2018. Household incomes and consumption growth remain weak, possibly due to a weaker housing market, particularly in Sydney and Melbourne.
New Zealand
While actual economic output continues to grow a persistent downturn in business sentiment has emerged. The ANZ business outlook survey reported that headline business confidence remained stubbornly low, with a net 37% of respondents reporting they expect general business conditions to deteriorate in the year ahead. The likely explanation for which confidence is being rocked is a combination of policy uncertainty, capacity restrictions and margin pressure.
Labour market conditions have now tightened to a point where we expect wages to (finally) begin to move higher. However the RBNZ took an unexpectedly dovish turn in the August MPS, despite expecting modestly higher inflation in the near-term, and it has reiterated this approach recently.
Summary
For New Zealand, our economy has been supported by the tailwinds of record-high Terms of Trade, low interest rates and strong population growth. Nonetheless, business confidence remains weak and points to an upcoming slowdown in growth led by a fall in business investment.
Globally the combination of strong growth and loose financial conditions was highly supportive for equities in 2017. This year we have seen a tightening of financial conditions alongside a divergence of global growth, with the US outperforming. In 2019, we see renewed economic convergence driven mainly by the US economy slowing at a time when inflation pressures and interest rates are increasing. We do not see a recession as likely in 2019. Without a recession, it is unlikely that profits fall. Without profits falling, it is unlikely that we see a sustained equity bear market.
There has been a cyclical increase in global economic activity over the past couple of years, but we believe the longer-term outlook for economic growth remains subdued with risks to the downside because of structural headwinds. The US – China trade talk news will underpin investor sentiment in the short term. In 2019, investors should ensure that their portfolios have a risk exposure consistent with their risk tolerance.
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Information and Disclaimer:
Source:JMI (previously JMIS), the investment consultant to the Select Wealth Management service.
This report is for information purposes only. It does not take into account your investment needs or personal circumstances and so is not intended to be viewed as investment or financial advice. Should you require financial advice you should contact Miles Flower on 021 645 000.
The near-term outlook for the world economy is still positive, however, mounting tensions over a potential US-China trade war suggests an elevated risk to the medium term outlook. We expect events in early July will likely be the key to understand the effect of this potential trade war, as the US is poised to impose the first significant tariffs at that time.
In the US, strong economic growth and low unemployment will likely prompt the Fed to raise rates two more times this year while, in the euro-zone, the ECB is on track to end its asset purchases by December. Any trouble in emerging markets could be largely confined to Argentina and Turkey.
Global
While world trade has softened in recent months, the stability in trade volumes recent months offers some reassurance. Although the protectionist measures and rhetoric have escalated in recent weeks, the consequences do not yet point to anything worse than a modest slowdown of a resilient global economy, supported partly by household spending expanding at a decent pace. Further ahead, however, with monetary tightening set to take a toll on the US economy next year and China losing some momentum, global growth is predicted to slow in 2019 and 2020. This assumes no catalyst. such as a severe trade war, eventuates prior to then.
The US
GDP growth should rebound in the second quarter, helped by the fiscal stimulus of recent tax cuts. This should keep pressure on the Fed to continue gradually hiking interest rates. Markets anticipate a total of four hikes this year and another two in the first half of 2019. As the stimulus fades and the cumulative monetary tightening bites, however, a slowdown in GDP growth could eventually force the Fed to reverse course by cutting rates around 2020.
In June, the Federal Reserve lifted its benchmark interest rate by a quarter of a percentage point, to a range of between 1.75% and 2%, the second rise this year. The last time the rate reached 2% was mid-2008, before the worst of the financial crisis. The Fed hinted at two more rises this year and dropped its statement that monetary policy would remain stimulative for some time.
The UK
The UK’s Monetary Policy Committee (MPC) is unlikely to wait too much longer before adopting more hawkish measures and increasing interest rates. Although the beneficial effects on exports of the pound’s fall may be fading, it is not clear that the sterling boost to growth is over. With sustained rises in real wages anticipated, real
GDP is likely to rise by around 1.5% to 2% over 2018/19. This should allow the MPC to raise interest rates at a faster pace than markets expect. Indeed, the Committee could hike rates in August, and by a further three times by the end of 2019.
Europe
The ECB recently announced its plans to end asset purchases this year, but it also clearly outlined that it is in no rush to raise interest rates. Investors’ expectations have now shifted to the view that the expansionary policy is set to continue and that the ECB will wait until late 2019 before raising interest rates.
The Italian financial markets are likely to remain under pressure in the coming months due to concerns about the new government.
Emerging Markets
The growing threat of a US-China trade war and a strong US dollar
are the key risks to emerging markets. Even if trade tensions don’t worsen, GDP growth in Emerging Asia has peaked and is likely to ease over the coming year. Central banks in Indonesia, Korea and the Philippines are likely to raise rates further before the end of the year, but other central banks in the region will be in no rush to follow.
Regional growth is likely to slow over the course of 2018-19 in Emerging Europe. The sharpest slowdown will come in Turkey, where the recent tightening of financial conditions will feed into weaker economic activity. Meanwhile, Argentina’s recently agreed IMF deal imposes an aggressive tightening of fiscal policy, which could push the economy into recession.
Australia
Although GDP remains strong, the end of the mining, housing and migration“booms” has softened the outlook for the economy and the financialmarkets. The result is that interest rates are unlikely to rise soon and the Australian dollar could weaken in response to rising US rates. There is a risk that tightening credit controls in response to the Royal Commission into Banking may conspire to weaken Australian housing.
The escalating trade spat between the US and China could potentially boost the Australian economy in the near-term, but any reduction in global trade would be bad news for Australia in the long-term.
Governor Lowe outlined in a speech in late June that, before interest rates are raised from their record low of 1.5%, the RBA will want to have“reasonable confidence that inflation is picking up to be consistent with themedium-term target and that slack in the labour market is lessening”. Weexpect rates to remain on hold until at least the second half of 2019.
In June, the AUD depreciated against the USD by -2.15%.
New Zealand
At home. the Reserve Bank of New Zealand left interest rates on hold at 1.75% in late June. Governor Orr repeated that the OCR will stay at the current expansionary level for a considerable period. Comparing this with the federal funds rate, which pushed higher in June to a target range of 1.75 to 2%, it is the first time since late 2000 that the OCR is lower than the Fed funding rate. In June, the NZD depreciated against the USD by -3.33%.
Summary
Global markets continue to face a more balanced set of tailwinds and headwinds than was the case a year ago. While the economic and earnings outlook remains relatively strong, the peaking of leading economic indicators and earnings revisions suggest a more challenging environment as momentum for both slows.
Monetary policy generally remains accommodative and the expectations are for future policy direction to be neutral at best, but more restrictive in the US with multiple rate hikes planned over the balance of 2018. We expect events in July are likely to be key to understand the extent of the impact of the US-China trade negotiations as the first significant tariffs are implemented. We will continue to monitor these events carefully to consider investment risk.
Also, geopolitical risks such as the instability in Italy endangering eurozone stability and the overhang of Brexit negotiations will be important to watch too.
Given the extended period of strength from investment markets, it is important that the risk levels in clients’ portfolios are appropriate.
Potential trade wars and interest rates have dominated the news in March. The first quarter of 2018 continues to show signs of more volatility and nervousness in markets particularly as the US, being furthest of the advanced economies through its cyclical growth, presents a different economic narrative to the rest of the world. Fundamental indicators of economic growth still suggest advanced economies are continuing to grow and stay strong, albeit against a backdrop of political risks surrounding the US’s move toward protectionist trade policies.
US
The Fed’s decision to raise interest rates in March by 0.25% was widely expected but some have been caught off-guard by the degree to which Fed officials increased their projections for future interest rate hikes. The median forecast for the Fed funds rate at the end of 2019 is now 2.75-3.00%, which until recently was at the hawkish end of the spectrum.
The direct economic impact of the tariffs which have been announced by the Trump administration are unlikely to be significant, and even if they are implemented in full, we suspect that any retaliation will be moderate. Businesses in the US are generally united against the tariffs, and Chinese retaliation would fall hardest on the ‘Farm Belt’ States that helped Trump win in 2016 and heavily rely on the export of soy bean to China. In that event, a trade war may be bad politics as well as bad economics. But the protectionist announcements and actions continue to weigh on investor sentiment as it is unclear that a moderated rational approach will win out in trade negotiations.
With the benefits of the fiscal stimulus, strong global demand and the weaker dollar, the Fed officials raised their forecasts for economic growth, with the median rising to 2.7% this year (from 2.5%) and 2.4% in 2019 (from 2.1%) which we consider slightly optimistic. As the fiscal stimulus begins to wear off and the cumulative monetary tightening starts to bite, GDP growth could slow in the second half of 2019.
China
The tariffs on Chinese imports outlined by President Trump are unlikely to have a big impact on the Chinese economy directly, and we think that the measures will end up being watered down. But as the recent market reaction highlights, there is a clear risk that investor sentiment continues to deteriorate and the damage from a further escalation of the trade conflict with China could be much greater.
In monetary policy, Chinese authorities are cutting the amount of cash local banks are required to set aside to cover bad loans, a move that would boost lenders’ bottom lines but potentially increase financial risk. With the sector struggling to boost profits, the country’s banking regulator will lower the provision coverage ratio for commercial banks—a requirement to safeguard their ability to weather losses—to a range of 120%-150%, from the current minimum of 150% of their bad loans. It is likely that the recent 5bp rate hike by the People’s Bank of China will not prevent market interest rates in China from continuing to fall, as they have done since the last rate hike in December.
Europe
The Euro-Zone should continue its expansion while allowing the European Central Bank (ECB) to wind-down its asset purchases this year, which would mark an end to a period of quantitative easing dating back to the financial crisis. We see it as unlikely that ECB will follow the US and raise interest rates anytime soon.
It is also likely that Europe will exercise restraint when considering retaliatory measures in the face of higher steel and aluminium tariffs, regardless of whether it is granted permanent exemptions, as its interests are to minimise the risk of trade conflict.
In the UK, news that an agreement has been reached on a transition period after the UK formally leaves the EU reduces the risk of a Brexit-related downturn. There is also mounting evidence of higher wage pressures, with average earnings growth at 2.8% in January and suggests that the Bank of England will be sooner, and more likely, to follow the US on interest rates.
Australia
In mid-March, the Reserve Bank of Australia (RBA) left interest rates on hold at 1.5% for the 17th consecutive meeting and it noted once again that progress in returning inflation to target is likely to be “gradual”, suggesting that a near-term rate hike remains unlikely.
Further ahead, we expect that interest rates will remain on hold until the second half of 2019. Aside from an acknowledgement that “market volatility has increased from the very low levels of last year”, the new policy statement wasn’t much changed from February’s statement. Indeed, the RBA retained its fairly optimistic view on the outlook for economic growth, saying that it expects the economy to “grow faster in 2018 than it did in 2017”.
The unemployment rate may need to fall from 5.5% currently to around 4.0% before wage growth rises significantly. This is partly due to the existing excess capacity not captured by the unemployment rate, but also as the natural rate of unemployment may be notably lower than most estimates of 5.0%.
The economy will probably cope reasonably well even though both the mining and housing booms are over, but over the next couple of years it is unlikely to strengthen as much as policymakers hope.
New Zealand
The Reserve Bank of New Zealand Governor Grant Spencer finished his six-month term leaving interest rates at 1.75% for the 16th consecutive month and reiterating that rates are unlikely to rise until the second half of 2020 The new Governor Adrian Orr is unlikely to begin with a bang when he takes over on Tuesday, not least because he will have to deal with a slowing economy and not enough inflation, but we can’t completely dismiss the possibility that he shakes things up a little.
The 2017 fourth quarter GDP report showed a healthy expansion with the RBNZ expected figures growing 0.7% and the trend appears to be in line with expectations and unaffected by an election transition. Weather extremes are likely to affect farming outputs however other well performing areas such as retail and services have contributed to the growth in the economy.
NZ’s underlying economic momentum should continue with the current trajectory of domestic demand growth that will continue to put pressure on capacity constraints and inflation wages over the course of 2018. There is a potential small divergence in business confidence as compared to Australia this year, some explanations suggest that it could be linked to uncertainty surrounding the policies of the new government in NZ. Best estimates are that GDP growth in Australia will accelerate from 2.3% last year to 2.5% this year while growth in New Zealand will probably hold steady close to 3.0% or perhaps drop slightly.
Summary
Global macroeconomic indicators still point to a global growth story despite markets becoming increasing cautious and volatile. The first rise in interest rates in the US suggests that inflation is around the corner. US protectionist policies are likely to affect market sentiment more than the fundamentals of economies.
Given the length of the economic recovery and period of strength from investment markets, it is important that clients’ portfolios are no more growth orientated than their long term strategic asset allocations.
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Information and Disclaimer:
Source:JMIS Limited, the investment consultant to the Select Wealth Management service.
This report is for information purposes only. It does not take into account your investment needs or personal circumstances and so is not intended to be viewed as investment or financial advice. Should you require financial advice you should contact Miles Flower on 021 645 000.
Aside from the February turbulence in equity markets, global economic growth should hold up well and inflation should remain low in 2018.
The recent hard economic data and survey evidence suggest that the world economy is growing at a rate over 3% pa and there is enough spare capacity in many economies for the expansion to continue for a while yet.
Meanwhile, although central bankers are reducing their policy support for this growth, they are doing so only gradually because inflation generally remains low. One explanation for the recent slump in equity and bond prices is that investors have become concerned that inflation is about to take off, forcing central bankers to tighten policy more rapidly than previously expected. However, underlying inflation has remained low and stable, even in economies which are closest to full employment.
US
Non-farm payrolls increased by 200,000 in January, following an upwardly revised 160,000 in December, and beating market expectations of 180,000. The share market reacted sharply downwards at the beginning of February to this strong number accompanied by private sector hourly wages increasing from +2.5% to +2.9%. This very good fundamental economic news was interpreted negatively in the context of a rising risk for inflation, and therefore interest rates. In fact, the jump to 2.9% year-on-year in January, which triggered the market sell-off, was exacerbated by temporary weather patterns and may yet be reversed.
The surge in the Conference Board’s consumer confidence measure to a 17-year high of 130.8 in February, from 124.3, underlines that household sentiment has not been knocked by the recent bout of stock market volatility. Instead, it has continued to strengthen, as households begin to see the recently passed tax cuts show up in their pay cheques. We expect the Fed to raise rates a total of three or four times this year, beginning with a 0.25% rise in interest rates in March.
China
China’s January CPI inflation moderated to 1.5% year-on-year and PPI inflation decelerated further to 4.3% year-on-year. Exports growth inched up to 11.1% year-on-year in January, in line with consensus, and imports growth rebounded sharply to 36.9% year-on-year, partially on distortions of Chinese New Year holidays, significantly above consensus. China has recently proposed removing the two-term limit for the presidency, in a move that would pave the way for Xi Jinping to remain in office beyond 2023 and tighten his grip on power and the economy.\
Japan
Japan’s economy grew at a slower-than-expected 0.5% annual rate in the December 2017 quarter, as strong exports failed to fully compensate for relatively weak domestic demand. The preliminary data released in February showed that Japan has now managed eight straight quarters of growth, the longest expansion period since the financial bubble of the late 1980s. The unemployment rate is now at its lowest level since 1993, while January national core CPI (excluding fresh food) was +0.9% year-on-year, unchanged from December. Japan recorded a turn to trade deficit in January, of ¥943.4 bn, from a surplus in December. However, we note that this often occurs in January due to seasonality and this latest deficit was around 15% narrower than in January 2017.
Europe
Eurozone concerns over the continued weakness of the US dollar were laid bare in a recent set of European Central Bank minutes that highlighted fears that the Trump administration was deliberately trying to engage in currency wars. The account of the ECB’s January monetary policy meeting also revealed that its hawkish members pushed for a change in the bank’s communications, arguing economic conditions were now strong enough to drop a commitment to boost the quantitative easing programme in the event of a slowdown
Australia
In mid-February, the RBA reiterated its forecasts for a more positive growth outlook in Australia and a gradual pick-up in wages and inflation. Even so, key uncertainties remain with regards to the amount of spare capacity in the economy, the speed of recovery in wages and the outlook for household consumption. The RBA will almost certainly leave interest rates on hold at 1.5% at its policy meeting in March and it will probably continue to signal that there is no risk of a near-term rate hike. Indeed, as progress in raising inflation to the 2-3% inflation target is likely to be slow, rates will probably remain on hold throughout 2018 and the first half of 2019 too.
New Zealand
If global equity markets are fearing higher interest rates, as this month’s fall suggest, then Australia and New Zealand offer something of an oasis as both the RBA and the RBNZ have recently dropped some heavy hints that they are in no rush to raise interest rates. This does not mean Australian and New Zealand equity markets are immune to any further global weakness, but it may mean that their bond yields do not rise as far as elsewhere; as well, their currencies may weaken.
Summary
While the sudden increase in market volatility in February raises concerns, we do not believe that the bull market in equities has yet come to an end. The underlying fundamentals of the global economy remain very strong. The synchronised global growth currently underway is the best level of economic activity seen this century. Strong global growth is contributing to the strong upward revisions to forward revenues and earnings for companies around the world.
While core inflation is still contained in much of the world, the continued strength in the labour market in the US has heightened fears that wage inflation there is finally taking root. With the US Fed already on a tightening path and with three to four further rate hikes priced in this year, the market has become concerned about the impact of higher long-term rates on equity valuations.
Higher bond rates reflect a stronger global economy and are typical during the latter stages of an economic expansion. Historically, this is also a period when equity returns can be very strong.
A diversified approach to portfolio construction remains appropriate.
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Information and Disclaimer:
Source:JMIS Limited, the investment consultant to the Select Wealth Management service.
This report is for information purposes only. It does not take into account your investment needs or personal circumstances and so is not intended to be viewed as investment or financial advice. Should you require financial advice you should contact Miles Flower on 021 645 000.
