The theme of a broadening global recovery continued to influence financial markets through September with investors actively seeking out relatively underrated opportunities outside the US. Investors continued to ignore largely growing geopolitical instability epitomised by the escalating war or words between the US and North Korea. Investors still pushed the US share market to a record high with the S&P 500 up 1.9% in the month, but they preferred opportunities in Asia and Europe. Japan’s Nikkei rose by 3.6% while Germany’s DAX rose by 6.4%. There were distinct share market laggards in September, characterised as markets less likely to benefit from global economic recovery. Britain’s FTSE 100 fell by 0.8% beset by uncertainties around Brexit. Australia’s ASX 200 was down by 0.6% influenced by increasing doubts about China’s future appetite for Australian commodities as well as worries about a stickily firm Australian dollar exchange rate.
Even though Australian economic readings were comparatively firm during September, international investors’ softer preference for Australian risk assets saw Australian credit lose a little ground in September. Interest rates drifted higher during the month in part led by the US where the Fed at its policy meeting reaffirmed it was likely to deliver another 25bps rate hike by year end and would also start a staged monthly selling program of its holdings of government bonds and mortgage-backed securities starting this month (October). The RBA left its cash rate unchanged again at its early September policy meeting at 1.50% and while indicating that no rate change was likely soon also made it clear in various statements that interest rates would most likely rise eventually. The US 10-year bond yield rose by 21bps in September to 2.33% and the 30-year Treasury yield rose by 13bps to 2.86%. The Australian 10-year bond yield rose by 15bps in September to 2.83%.
US financial markets were more volatile through September as the disturbing news flow on the developing crisis in North Korea and severe weather events in the US jostled with positive news that the US economy continues to recover and that the President was starting to find a way to negotiate with Democrats in Congress to defuse the debt ceiling threat and potentially revitalise tax cuts. The final revision of Q2 US GDP showed annualised growth at an above trend 3.1% with strong growth contributions from consumer spending and business investment. Productivity is improving in the US, company profits continue to rise, wages are slowly lifting and employment growth is still strong after allowing for temporary job losses in the wake of Hurricanes Harvey and Irma. Inflation is still holding relatively low too, although there are some signs that higher inflation is not too far away. US economic developments remain on balance risk asset friendly. Eventually, rising interest rates will probably cause the long bull market in US risk assets to end. The next rate hike from the Fed, probably in December combined with the first few months of Fed asset sales may in our view cause interest rates to rise enough to dampen and possibly even throw in to reverse net investor buying of US risk assets.
In China, the economic readings are consistent with annual economic growth stepping down to around 6.5% in Q3 from 6.9% in both Q1 and Q2. Slower growth is the cost of economic reform in China on several fronts. The battle to batten down excessive investment demand for housing continued through September with local authorities in China’s bigger cities imposing stricter limits on multiple home ownership. Annual growth in home prices in China is sliding fast, down to 8.3% y-o-y in August, from 9.7% in July, and with several cities reporting falling house prices. The battle to clean up China’s most polluting industries continues too. While China is trying to balance conflicting growth pressures from economic reform, temporarily weighing down growth, and an overarching need for the economy to grow at reasonably strong pace it is also facing diplomatic pressures that could impact growth too. China is being asked by the US and its allies to play a greater role in influencing the rogue North Korean regime to achieve an outcome -potential regime change in North Korea – that China views as adverse to its interests. This poisonous diplomatic chalice is being linked to the willingness of the US and others to trade freely with China. It is becoming increasingly hard to see how China’s international trade will not suffer from the North Korean impasse. The downside risks to China’s growth prospects are becoming more pronounced in our view.
Europe continues to be the stand out in terms of upside economic surprises.
Global economic recovery is helping to lift demand in Europe and there are signs that internal demand in Europe is lifting too with relatively strong household spending aided by an unemployment rate that has fallen over the past two years from well above 10% to currently around 9%. European consumer sentiment is the strongest since the beginning of the century. European businesses are investing more too and while there are still uncertainties in Europe, annual GDP growth is becoming entrenched above 2% y-o-y. The ECB is still well placed to keep a very growth accommodating monetary policy stance although if the current signs of economic improvement continue, the ECB may have to accelerate the retirement of QE asset purchases at the very least in 2018 and possibly start to lift interest rates too.
In Australia, while GDP growth improved in Q2 to 1.8% y-o-y and should lift well above 2% in Q3, the outlook beyond still looks bumpy. Households spent more in Q2 by running down savings but there is a limit to this trend continuing with household debt so high and wages growth so low. Housing activity is becoming increasingly difficult to call with any confidence. House prices in Brisbane, Melbourne and Sydney appear unsustainably high on several metrics but are topping out in a surprisingly orderly fashion so far. It is still likely, however, that housing activity will detract from GDP growth for at least the next year or so. Business investment spending may be on the cusp of a turn for the better, but that probably depends on households continuing to lift their spending. Strong employment growth points towards stronger household spending and a possible lift in wages growth before long may add momentum. Australian exports should benefit from stronger global growth, but the changing shape of Australia’s biggest market, China, as it seeks a cleaner future may count against some of Australia’s biggest commodity exports.
The RBA continues to forecast that the lumps and bumps in Australia’s economic outlook will iron out over the next year or so leaving above trend economic growth beyond and annual inflation migrating to the middle of its 2-3% target band. It is fair to say that the RBA’s forecasts are looking more realistic than they did earlier in 2017. There are still downside risks to the RBA’s forecasts – an international trade war; sharp weakening in China’s growth rate; a collapse in Australian house prices – but these risks are no worse than they have been for some time. In contrast, potential upside risks to the RBA’s forecasts are growing, not least of which are the improving global growth outlook and the persistent and surprising strength in Australian employment growth this year so far. If the RBA’s forecasts are accurate it is likely that that it will start hiking the cash rate in 2018, probably early in the year at its February policy meeting. At this stage we see another three rate hikes in 2018 beyond the February hike taking the cash rate to 2.50% by the end of the year. It is worth keeping in mind that if annual real GDP growth pushes up to 3% y-o-y in 2018 and CPI inflation moves up to 2.5% -both reasonable forecasts – it is hard to see how the cash rate can be any less than 2.50% by the end of next year.