Risk assets finished 2016 on a high note assisted by signs of stronger global growth, notably better US growth, plus an initial assessment that US President-Elect Trump may promote stronger US growth. Interestingly the willingness of financial markets to focus on the good parts of Trump’s policy proposals – lower taxes, more government spending and less regulation – is at odds with a sense that bad Trump may come first – bullying US companies that want to promote labour-saving efficiencies, tearing up free trade arrangements, indulging in policy brinkmanship with the Federal Reserve and cutting back immigration. Signs of better growth and hope that good Trump prevails saw major share markets rally in December even in the face of a rate hike by the US Fed and a continuing upward drift in bond yields. Among major share markets the best gain during the month came from Germany’s DAX, up by 7.9%. The US share market made a new record high and the S&P 500 was up by 1.8%. Even though Australia was an odd-man-out with signs of weaker economic growth, the ASX 200 made a strong gain in December rising by 4.2%.

The strength in share-markets in December helped to promote a rally in Australian credit and notwithstanding brief concern about Australia’s AAA sovereign credit rating just ahead of the release of the Government’s Mid-Year Economic and Fiscal Outlook Statement. In the path towards returning the Budget to surplus early next decade was sufficiently credible to prevent the credit rating agencies from adjusting Australia’s sovereign rating, at least in the near-term. The December policy meeting of the US Fed delivered a 25bps hike in the funds rate to 0.75% to 1.00% range as widely expected. Less expected was an indication that the funds rate might be hiked three times in 2017 and a fairly explicit warning that President-Elect Trump’s plans fiscal expansion plans were not needed to boost an economy already moving up towards capacity and that interest rates may need to move up further than the three hikes indicated. After the sharp increases in US bond yields in October and November the increases in December were only modest. The US 10-year bond yield rose in December by 5bps to 2.44%, while the 30-year Treasury yield was up by 7bps to 3.07%. The Australian 10-year bond yield rose by less than its US counterpart, up only 2bps in December to 2.76%. The RBA left the cash rate unchanged at 1.50% at its early December policy meeting with no indication of any move in the near future.

Returning to the US economy, the strongest proof of improving economic activity is in the pattern of GDP growth in 2016 from 0.8% annualised pace in Q1 to 1.4% in Q2 and 3.5% in Q3 on final revision. Importantly household spending is generating much of the improvement in US growth and previously weak business investment spending has risen in Q2 and Q3. Leading indicators of activity in both US manufacturing and non-manufacturing (services) were both strong in December. The ISM manufacturing index rose to 54.7 from 53.2 in November while the ISM non-manufacturing index was steady at 57.2 in December. Both readings speak of strong Q4 GDP growth as too do consumer sentiment and confidence readings travelling at cycle high readings in December and most housing activity indicators too. The only slight patches of weakness in the US growth story relate to rising international trade deficits and a tapering strength in non-farm payrolls, up 156,000 in December after rising by an upwardly revised 204,000 in November.

One issue with the strength of the US economy is that there are flickering signs of a potential lift in inflation. Average hourly earnings rose by a greater-than-expected 0.4% m-o-m in December lifting the annual change to a cycle-high 2.9% y-o-y. Wages growth above 3% y-o-y in the US is widely regarded as tending to underpin growth in inflation. If inflation shows further signs of lifting and President-Elect Trump actively pursues his plans for fiscal expansion there is a real risk that interest rates may rise much more than is widely expected currently. The outlook for the Fed’s interest rate policy is more uncertain than usual and couched in their terms they are waiting to see what happens before making their moves on the funds rate. There is enough strength in US economic data for the Fed to deliver another 25bps rate hike either at its late-January policy meeting or the one after in March.

In China, the signs are that Q4 2016 GDP growth due next week will again show annual growth around 6.7% y-o-y. November economic readings were almost all a touch stronger than expected. In particular, urban fixed asset held up at 8.3% y-o-y, in part driven by government spending, and retail sales growth accelerated to 10.8% y-o-y from 10.0% in October. The mainstream economic numbers paint a picture of growth stabilizing and rebalancing the way the authorities would like. But there are also signs of increasing instability below the surfaces – too rapid escalation in house prices, too much housing construction, increasing problems in the bond market and burgeoning problems in bank and non-bank lending. One issue is that when the residential construction boom fades, probably mid-2017, there could be a significant pot-hole in China’a GDP growth rate resurrecting hard landing fears. Mean-time, for the next few months, the economic numbers may continue to looking reasonably good.

In Europe, most economic indicators are consistent with GDP growth maintaining at least the 1.6% y-o-y annual paced reported in Q3 2016. Various December leading economic indicators are looking quite promising. The combined business and consumer confidence indicator lifted to 107.8 from 106.6 in November. The December manufacturing PMI was comparatively strong at 54.9 while the services sector PMI lifted to 53.7 from 53.1 in November. Encouragingly, Europe’s unemployment rate moved below 10% in the closing months of 2016, down to 9.8% in October and expected to hold that level in the November reading due this week. Inflation is finally starting to rise in Europe too, up to 1.1% y-o-y in December from 0.6% in November. The ECB continues its purchases of bonds and other securities from European banks but announced that it would start tapering those purchases at its December policy meeting while also extending the duration of the purchase program from ending in March 2017 to not ending before the end of 2017 at earliest. Europe still has fragile banks and a list of potentially problematic national elections this year plus ongoing Brexit issues, but at least economic growth is a little more assured than it has been for some time.
The Australian economy was an unusual odd-man-out in December exhibiting signs of weaker growth. An unusual combination in Q3 2016 of falling housing activity, falling government investment spending and weakness in net exports led to a negative Q3 GDP reading, -0.5% q-o-q sharply reducing annual growth from a downwardly revised 3.1% y-o-y in Q2 to 1.9% in Q3. Financial markets briefly toyed with the idea that the surprising weakness in Q3 growth might jolt the RBA to cut the official cash rate further in 2017. Rate-cutting speculation was short-lived as it became clear that the factors leading to the Q3 negative GDP growth result were essentially one-time with at least one, net exports, likely to reverse sharply in Q4. Exports powered ahead by nearly 8% in November alone resulting in the monthly trade balance moving from $A1.1 billion deficit in October to $A1.2 billion surplus in November. Net exports may contribute more than one percentage point to GDP growth in Q4 2016 (data due in early March) sufficient to prevent a second consecutive negative GDP quarter.

Apart from net exports, the labour market data took a firmer turn in November too with employment increasing by 39,100 and with a rare show of strength for full-time employment, up 39,300. Retail trade data for October was promising, up 0.5% m-o-m. One developing area of potential weakness is housing activity. Although sales of homes are still holding up, home building approvals have started to fall sharply, down by 12.6% m-o-m in October after falling by 9.3% in September. Lending institutions have become increasingly wary about lending for certain types of new homes and have become extremely wary about lending to small property developers. After three years of rapid house price escalation in Sydney and Melbourne, the housing market is precariously poised and potentially vulnerable to pockets of over-supply; rising mortgage interest rates and particularly a raft of restrictions placed on investors from China trying to move money out of the country. Most likely housing activity will make a noticeably weaker contribution to Australian economic growth in 2017.

From the RBA’s point of view there are good reasons to wait and see what develops in the global economy as well as how well or otherwise growth is supported locally. There are few compelling reasons to adjust monetary policy in the near term. At this stage the cash rate is likely to remain at 1.50% through to the middle of 2017 and even then the chances of a cash rate change are not high. Australian lending interest rates, however, may continue to move higher led by developments in international bond markets.