Risk assets mostly strengthened in May, despite a brief change in the market’s assessment of the likelihood of a rate hike by the US Federal Reserve (Fed) at its next policy meeting in mid-June. Several senior Fed officials, including Chairman Yellen, spoke about the possibility of a June rate hike, although more recent, unexpectedly soft US labour market data has tempered rate hike expectations. All major share markets rose in May with the exception of the British FTSE 100, down by 0.2% and where the potentially disruptive Brexit referendum is looming later in June. Japan’s Nikkei enjoyed the strongest gain in May, up 3.4%, supported by increasing expectations of growth-supportive monetary and fiscal policy changes. Australia’s ASX 200 rose by 2.4% with some assistance from the RBA’s decision cutting the cash rate by 25bps to 1.75% at its early May policy meeting.
Australian credit improved again in May, building on gains in April and March and assisted by better local and international investor sentiment regarding Australian risk assets in general. On the interest rate front, it looked for a period in mid-May that the US Fed was priming the market to expect a rate hike at its June policy meeting, a move much against the grain of central banks’ stable or easing policy moves elsewhere. The RBA, for example, cut its cash rate by 25bps at its May policy meeting because of persistently low inflation. In its latest inflation forecasts also released in early May it made it plain that sub-target inflation could persist for the next two years providing scope for an even lower cash rate. Bond yields responded to their respective central bank’s cash rate signals. The US 10-year bond yield rose in May by 2bps to 1.85%, while the 30-year treasury yield fell by 3bps to 2.65%. The Australian 10-year bond yield, against the yield rising lead from its US counterpart, fell by 24bps to 2.27%.
Returning to the US economy GDP growth moderated noticeably in late 2015 and early 2016 with GDP growing at 1.4% annualised pace in Q4 2015 followed by only a 0.8% lift in Q1 2016. Personal consumption spending and particularly residential housing activity have been the mainstays of what US growth there is. Manufacturing activity and business investment spending have been weak. April readings of new housing activity have been very strong and there has been a noticeable rise in personal consumption too, up 1.0% m-o-m. The housing and consumption data point to better US growth in GDP developing in Q2, although May purchasing manager reports and especially May nonfarm payrolls – up only 38,000 after a downwardly revised 123,000 lift in April – point to the opposite. These mixed-strength US economic readings heighten the risk that if the Fed hikes the funds rate in June, it could promote an unwanted downturn in US economic activity. Despite the talk of June being a live policy meeting back in mid-May the softer turn in the data since makes that less likely.
In China, a run of softer-than-expected April economic readings plus flattish manufacturing sector and services sector purchasing manager reports for May point to a comparatively soft rebound in GDP growth in Q2 from the 6.7% y-o-y reported for Q1. The main three monthly readings for April all showed unexpected deceleration. Industrial production rose 6.0% y-o-y, from 6.8% in March. Retail sales rose 10.1% y-o-y from 10.5% in March and urban fixed asset investment spending rose 10.5% y-o-y from 10.7% in March. The one point of strength in April was an unwelcome one. House prices accelerated to 6.2% y-o-y from 4.2% in March providing a sign that monetary policy easing may have served only to drive up house price inflation and possibly poor bank lending practices too. The Government indicated that it has become more cautious about further policy easing moves, a sign that if growth is a little softer there may be no quick policy easing response as has happened repeatedly over the past two years.
In Europe, GDP growth was surprisingly strong in Q1 2016, up by 0.6% q-o-q, 1.6% y-o-y. Europe’s unemployment rate was steady in April at 10.2% while deflation moderated to -0.1% y-o-y in May from -0.2% in April. The ECB left monetary policy settings unchanged at its early-June policy meeting and its future policy course will depend upon whether the growth outlook in Europe continues to stabilize. The Greek sovereign debt problem faded further on the latest negotiations with creditors. The Brexit vote in the UK later in June is being watched for any repercussions in other EU member countries. At this stage, the UK is expected to vote to stay in the EU, but confidence about the outcome is decreasing.
Australian economic growth surprisingly strengthened in Q1 with real GDP up by 1.1% q-o-q and 3.1% y-o-y. Net exports drove almost all of the growth and domestic demand rose only 0.1% q-o-q, 0.9% y-o-y helping to explain why employment growth was noticeably less robust in the early months of 2016. Another point of weakness in the GDP data was falling prices accounting for why nominal GDP rose by only 0.5% q-o-q, 2.1% y-o-y. The configuration of comparatively strong real economic growth – predominantly export driven – but with struggling nominal GDP growth, weak company profits growth, down a further 4.7% q-o-q in Q1, and very soft wages growth, up only 2.1% y-o-y in Q1, looks set to continue. In these circumstances, the RBA is more likely to focus on weak inflation rather than apparent strength in real GDP.
The RBA produced its latest growth and inflation forecasts in early May as part of its quarterly Monetary Policy Statement. The biggest change relative to its forecasts produced three months earlier was to cut a percentage point off its end 2016 inflation forecasts and half a percentage point off inflation forecasts beyond. As a result, the RBA now forecasts that headline and underlying inflation will sit below its 2-3% target band over the next two years. The RBA is likely to view too low inflation as a sign that economic growth could be better. That is why very low inflation implies more room for the RBA to cut the cash rate further. We expect that when the RBA revisits its growth and inflation forecasts in August and November it will also recommend that the RBA board cuts the cash rate by a further 25bps in each of those months taking the cash rate down to 1.25% by the end of 2016. The low inflation outlook also implies very low interest rates persisting through 2017.