Risk assets traded a narrow range through August with the negative influence of heightened geopolitical concern mostly offset by mounting evidence that global economic growth is gathering pace and remarkably with little sign of inflationary pressure. Central banks seemed to take a pause from their earlier comments priming markets for less liquidity support and higher official interest rates allowing bond markets to recalibrate yields a little lower in some cases. In Australia too, economic readings released through the month pointed to stronger growth and still well-contained inflation. Among share markets, the performance of the Australian ASX 200 was again middle-of-the-pack down by 0.1%. The European Eurostoxx 50 fared best, up by 0.8% and Japan’s Nikkei the worst, down by 1.4%. The US S&P 500 was up by 0.1% and continues to trade close to a record high.
The Australian credit market was stronger again in August with local banks continuing to find favour with investors. The US Fed, after providing guidance in June and July that it would start winding down its balance sheet and deliver another 25bps rate hike by year-end seemed to take a more dovish stance and provided no strong leads at the annual Jackson Hole central bankers’ gathering which in the past has often been a platform for providing key monetary policy messages. The RBA at its August policy meeting, subsequent quarterly Monetary Policy Statement and Governor’s appearance before the House Economics Committee also confirmed no desire to change the 1.50% cash rate in the near term, although there was a warning that the next rate change when it arrives eventually is more likely to be a rate hike than a rate cut. The US 10-year bond yield fell by 18bps in August to 2.12% and the 30-year Treasury yield also fell by 18bps to 2.73%. In contrast, the Australian 10-year bond yield rose by by 1bps in August to 2.68%, reflecting in part that RBA comments were less dovish through the month than those from US Fed officials.
The key influence on US financial markets through the month appears to have been evidence that the US economy is gathering strength and without undue inflation pressure at this point. One key marker of US economic improvement is that GDP growth has lifted in Q2 to 3.0% annualised pace from 1.2% in Q1 and with US household spending leading the charge. Latest monthly economic readings point to a strong start to Q2 GDP growth as well. An accelerating US economy strongly boosting the earnings of US companies and with no real risk that the Fed will act too quickly to slow things down means that US risk assets are for the time being taking negative news in its stride whether that be heightened risk of war on the Korean Peninsula, natural disaster in Texas, or a looming stand-off on the US budget and debt ceiling. Nevertheless, US risk assets are richly valued and have factored in a strong economic outlook. The balance is becoming increasingly fine in our view between US risk asset positive and negative influences.
In China, the economic readings relating to July and announced in August were mostly softer and hint at small slippage in annual GDP growth in Q3 from the quite rapid 6.9% y-o-y reported in Q1 and Q2. In part, the slower growth rate is a consequence of policy actions aimed at dealing with issues of poor quality bank lending and excessive spending on residential real estate. The continuing reform of state-owned enterprises is also weighing on growth. China’s authorities are adept at managing the inherent incompatibility between growing the economy at 6.5% or better and the growth-crimping effects of economic reform. The latest purchasing manager information from China’s manufacturing sector indicate a turn to stronger growth in August. One issue now looming, however, is that China may soon need to make a choice between whether to continue trading with North Korea and risk the US closing off its trade with Chinese companies. It is very hard to predict developments in North Korea and responses from the rest of the world. One increasingly likely development is a marked toughening of US trade restrictions on US companies dealing with North Korea and its key ally, China. The risk of a marked down-turn in China’s exports causing a pull-back in China’s growth rate is growing. The policy response from China then becomes important too. It is possible, indeed likely, that China would lift sharply government spending. China’s growth prospects may not necessarily be a lot worse if greater US trade restrictions are imposed.
Europe continues to be the stand out in terms of upside economic surprises. Annual GDP growth improved to 2.2% y-o-y in Q2 from 1.9% in Q1. The European unemployment rate was 9.1% in both June and July – a decade low reading. Underlying annual inflation has cracked the 1% y-o-y mark and was up to 1.2% in July. Retail sales continue to rise strongly and were up another 0.5% m-o-m in June after lifting 0.4% in May. While there is no urgency for the European Central Bank to start lifting interest rates, if Europe’s economic recovery continues it is likely that the ECB will start to talk about higher interest rates in 2018 and could deliver in 2019.
In Australia, just ahead of the Q2 GDP release this week, it is becoming clearer that economy is gathering pace. Employment has been rising strongly since the end of Q1. Business surveys report stronger trading conditions and are optimistic about future trading conditions. Stronger world growth is supporting Australian exports. The potentially weakest part of the Australian economy, housing activity, is showing signs of swooning rather than collapsing. The previously weakest part of the economy, business investment spending is showing signs of picking up. All told, it is increasingly likely that annual GDP growth will accelerate through the second half of 2017.
The Australian economy still faces potential headwinds. Household debt is precariously high and household budgets are extremely stretched. Housing activity although not collapsing is still likely to pull back and detract from growth over the next year or two. Nevertheless, the RBA’s “glass half full” economic forecasts are starting to look realistic. Although inflation is still currently tame at 1.9% y-o-y in Q2 there are signs – rising energy prices, rising prices for manufactured goods and the increasing likelihood that wages growth will not stay quite as low as it has been – that inflation may climb in to 2-3% range from mid-2018 as the RBA is forecasting in its latest quarterly statement. 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.