Global share markets suffered a second consecutive month of sharp falls as a range of concerns more than offset evidence that the global economy is in good shape. Among investor concerns during the month the most disturbing is the risk of a global trade war on the escalating tit-for-tat imposition of tariffs by the world’s two biggest economies the United States and China. If the threat of trade war increases and encompasses more Asian economies and spreads to Europe the risk increases of a global economic recession occurring in 2019. Most share markets are still richly priced even after the falls in February and March and would need to adjust much lower if prospects firm of a trade-war-driven global economic recession in 2019. Complicating matters, strong momentum is still running in global economic growth and if the risk of a trade war fades global share markets would likely recover and probably sharply. There is increasing uncertainty surrounding whether the forces supporting strong global growth, or the opposite, will prevail promoting greater volatility in share markets. High volatility seems likely to feature in share-market trading for some months until the outlook for global growth becomes clearer.
Share market trading showed a similar pattern in March to that displayed in February. Large falls were followed by strong but still partial recoveries ahead of renewed falls. The best performing major share-market over the month was the European Eurostoxx 50, down by 2.3%, but coming after one of the worst performances in February when it fell by 4.7%. In contrast, Australia’s ASX 200, the best performing major share-market in February falling only 0.5% was down the most in March, falling by 4.3%. At times, the two highest weighting sectors. Financials and Resources both came under selling pressure, Resources because they are most vulnerable to a worsening trade war and Financials as revelations at the Banking Royal Commission of poor bank lending practices and corporate culture reinforced existing concerns about how Australian banks can reform and grow their businesses in the future. The US share market after a very strong gain in January has given up all gains from that month and more beset by trade war concerns, news of poor business practice in the key tech sector and increasing recognition that the Federal Reserve (Fed) will keep hiking interest rates. The US S&P 500 fell by 2.7% in March after falling 3.9% in February.
Australian credit spreads widened over the month although the weakness was not as pronounced as in the Australian share market. Despite the Fed hiking its funds rate at its March policy meeting by 25bps to 1.75% and reinforcing expectations of at least two more hikes this year, longer-term bond yields rallied in March in part reflecting safe-haven buying by investors but also a sense that if a trade war develops compromising US economic growth the Fed could find itself needing to cut rather than hike rates at some point in 2019. The US 10-year Treasury yield fell 12bps in March to 2.74%, while the US 30-year Treasury yield fell by 15bps in March to 2.97%.
The mid-March rate hike by the Fed reinforced the difference between the US Fed’s rate hiking program – six 25bps hikes since the first in this cycle in December 2015 and at least another two expected this year – and the RBA’s policy stance – has not started hiking yet and the first still seems to be several months away. One consequence of this big difference in monetary policy direction between the USA and Australia is that Australian bond yields have moved below US bond yields and the gap in yields is widening with Australian bond yields under less pressure to rise than their US counterparts looking forward. In March, the Australian 10-year bond yield rallied more than its US counterpart, by 17 bps to 2.60% and widened the gap in yield below the US 10-year bond to 14bps from 9bps at the end of February. The difference in likely monetary policy moves in Australia and the US could increase this 10-year bond yield gap to 50bps or more later in 2018. Shorter-dated bonds are likely to experience an even bigger yield gap. This widening yield gap could have significant ramification for the funding costs of Australian banks that rely heavily on offshore funding, especially from the US. It is possible that higher offshore funding costs could lead Australian banks to start increasing lending interest rates well-ahead of the RBA’s first cash rate hike.
Forecasting when the RBA is likely to start hiking its cash rate is becoming harder as a wider range of opposing forces influencing prospects for growth and inflation come in to play. One key areas of uncertainty already mentioned concerns whether a broader trade war develops weakening global economic growth prospects and tipping a big exporter such as Australia in to recession. In this circumstance the RBA is unlikely to hike the cash rate, but it may also be limited in its ability to cut rates by the impact of much higher import costs driving up inflation.
Other local areas of uncertainty relate to the considerable strength in Australian employment growth (which on the latest official job vacancies for February, up 4.3% q-o-q, 19.3% y-o-y may become even stronger) which could prompt an earlier and sharper lift in wages bringing forward the first RBA cash rate hike. On the opposite side, the heavily indebted household sector, notwithstanding strong employment growth is looking potentially fragile, especially if price falls continue in key housing markets such as Sydney as seems increasingly likely.
Unsurprisingly, The RBA is in no hurry to hike the cash rate while so much uncertainty surrounds the economic outlook. Its base case remains that GDP growth will slowly accelerate above trend later this year and inflation will lift slowly in 2019 but it wants more evidence that its forecasts are on track. If it gets that evidence over the next few months (and our view is that there is a very good chance it will get that evidence) it will probably start hiking the cash rate probably in August or September. Our view remains that there will be sufficient strength in Q2 2018 wage and CPI reports to warrant the RBA hiking the cash rate in August or September. Intriguingly, as mentioned earlier, when the RBA starts hiking rates it may prove to be an academic exercise for Australian borrowers as their banks may have already started to lift lending rates because of higher offshore borrowing costs.