Risk assets were mixed-strength in January. The strong rally in share markets in the wake of President Trump’s election win started to fade amid recognition that President Trump is going to try and do what he promised in the election campaign with a fair chance the bad – immigration restrictions and disputes with other countries – come before the good – deregulation and fiscal expansion. Economic readings internationally maintained a firm tone on balance, especially in the United States. Despite stronger growth and some signs of rekindling inflation the US Federal Reserve decided to wait and watch at its latest policy meeting although the Peoples’ Bank of China surprised by starting to lift official lending interest rates, albeit by only 10bps. Among major share markets the best gain during the month came from the US S&P 500, up by 1.8% and finished the month on a record high. European share markets were mostly weaker in January and Eurostoxx 50 fell by 1.8%. The Australian ASX 200 fell by 0.8%, but that came after a 4.2% gain in December.
Despite gyrating sentiment in share markets in January credit spreads continued to tighten and Australian credit rallied. After the pronounced selling in government bond markets in the final quarter of 2016, bond markets stabilised through January although towards month end there were signs of yields starting to rise again. While the US Federal Reserve left its funds rate unchanged at its January 31st/February 1st policy meeting its upbeat comments on the US economy and statement that US inflation “will rise” point to the likelihood of another rate hike soon. The US 10-year bond yield rose in January by 1bp to 2.45%, while the 30-year Treasury yield was down by 1bp to 3.06%. The Australian 10-year bond yield fell by 5bps in January to 2.71% although has since risen in the first week of February by 8bps to 2.79%.
Returning to factors influencing US financial markets, the strong sense that President Trump’s America First policies will fire up business and consumer spending is adding momentum to an economy that was already expanding quite well. Consumer confidence and sentiment were at or close to cycle highs in January and surveys of home building activity, manufacturing and non-manufacturing businesses are pointing to strong expansion. Annualised GDP growth averaged 2.7% in the second half of 2016, more than double the pace in the first half. The latest nonfarm payrolls report for January showed a big step up to +227,000 from +157,000 in December.
The US economy growing well is using up spare capacity fast and even though the latest wages growth readings were a touch softer than expected there is now little doubt that US inflation, already tracking just above 2% y-o-y will move higher. The Federal Reserve has indicated three rate hikes through 2017, but the risk is that there will need to be more if the economy continues to gather momentum, inflation rises and if President Trump delivers fiscal stimulus to an economy already growing close to capacity. The risks seem skewed to the upside for US bond and Treasury yields.
In China, too, the monetary policy outlook is shifting but reflecting more a shifting emphasis in policy aim. Through much of 2016 monetary policy was working together with expansionary fiscal policy to support growth. That growth came but with too much contribution from residential construction and unwanted excessive growth in house prices and further deterioration in the quality of bank lending. Monetary policy is being reassigned early in 2017 towards tempering the excesses in residential real estate. Some of the Peoples’ Bank’s key lending rates have been raised by 10bps, the latest move coming last Friday. This change in monetary policy aim means less support for GDP growth and possibly a quite significant pull-back in residential construction spending later in 2017. There is a risk of a pot-hole in China’s GDP growth rate, beyond what will still be quite strong growth in Q1 and probably Q2.
In Europe, most economic readings took a stronger turn in late 2016. Q4 GDP accelerated to 0.5% q-o-q, 1.8% y-o-y. The unemployment rate moderated to 9.6% in December almost a full percentage point less than where it was a year earlier. Inflation is starting to lift, up on the preliminary numbers for January 2017 to 1.8% y-o-y. Government support programs have been put in place for some of the weakest banks. Europe, especially Germany, is benefitting from the comparatively weak euro exchange rate, although this is also causing the Trump Administration to start focusing on Germany as a country taking unfair advantage of a weak exchange rate. Europe still faces difficult national elections that could throw up results capable of fracturing the European Union. Britain’s exit from the EU is also still a negotiating nightmare. Nevertheless, the underlying economic readings are improving for the most-part improving making Europe’s relatively under-valued share markets tempting for investors and adding another potential pressure point to rising bond yields.
The Australian economy, after suffering reversal in Q3 GDP which fell by 0.5% q-o-q seems to have rebounded very strongly in Q4. The Q4 GDP report will not be released until 1st March but several signs are emerging of a strong rise. One of the biggest changes between Q3 and Q4 will come from international trade. Australian exports had bumper months in November and December initially lifting the international trade position out of deficit to a surplus of $A2 billion in November and then extending that to a record surplus of $A3.5 billion in December. Net exports alone will contribute around a percentage point to Q4 GDP in real terms and around two percentage points to nominal GDP. There are also signs that household consumption spending, housing activity and government spending will make positive contributions to Q4 GDP as well.
Set against the approaching rebound in Australian economic growth, inflation remains subdued and below the RBA’s 1-2 % target band. Headline CPI and underlying annual inflation were all close to 1.5% y-o-y in Q4 2016, but those results were exactly as forecast by the RBA back in its November Quarterly Monetary Policy Statement. The RBA, therefore, has no reason to adjust its inflation forecasts in its next Quarterly Statement due later this week, but it does have stronger reason to expect that growth will accelerate over time. Also, there are signs developing that low borrowing interest rates are having an undesirable effect helping to underpin house price inflation and driving excessive growth in lending for investors in housing. Financial stability issues are probably starting to figure more prominently on the RBA’s policy radar. It seems to us that the RBA will take a lot of convincing that further cash rate cuts are needed. Instead, the RBA is likely to keep the cash rate on hold at 1.50% for an extended period and the next rate change when it comes is more likely to be a hike. At this stage, we are penciling in a 25bps hike to 2.00% in Q1 2018.