Global share markets showed mixed fortunes in May and among the major share markets movements ranged from a 2.2% increase for the US S&P 500 to a 3.7% fall for the Eurostoxx 50. The widely differing performances of major share markets in May reflected a range of rising and ebbing concerns including whether evidence of moderating global economic growth in the early months of 2018 implied a deepening economic downturn; concern about a potential crisis in several emerging markets; on-off US/North Korea talks; continuing political stalemate in Italy with the potential to create existential risk for the euro; and heightened Middle Eastern tension combined with volatility in the outlook for global oil prices. Share market movements were volatile at times through the month reflecting the range of concerns. Several of these concerns became much less prominent by the late part of May and in early June. Perhaps the most important change was that the run of economic data, notably in the US, took a stronger turn providing hope that the slowing pace of global economic growth in Q1 is temporary and that growth will start to gather pace again in Q2.
The Australian share market had a volatile run through May too, buffeted by international concerns as well as home-grown concerns related to more revelations at the Banking Royal Commission about poor banking and insurance business practices. Amid the turmoil there were also some reasons to take a more positive view of Australian shares. Strong commodity prices continued to boost the earning prospects of Australian resource companies. The Government’s Budget in early May was mildly growth positive. The RBA’s quarterly Monetary Policy Statement released in early May was still upbeat in forecasting stronger Australian economic growth later in 2018 and in 2019 but with no imminent pressure to start hiking the official cash rate. The ASX 200 managed one of the better gains among international share markets in May, rising by 0.5% in the month.
Australian credit suffered a more volatile month in May and spreads widened. Credit came under selling pressure internationally challenged by worries about emerging markets – Argentina and Turkey in particular; the high yield sector of the US corporate market; and heightened concern about Italian debt and the euro driven by the continuing stalemate forming an Italian Government. By the beginning of June, these concerns adversely impacting international credit were showing signs of becoming less pronounced.
The volatility in May in risk assets such as shares and credit generated some “safe-haven” buying of US and Australian government bonds. The US 10-year Treasury yield and 30-year bond yield both fell by 9bps to respectively 2.86% and 3.03%. The Australian 10-year Government bond yield fell by 10bps to 2.67%. This pull-back in bond yields may prove to be short-lived in our view if the early-June brightening risk asset outlook continues.
The US Federal Reserve remains upbeat about US economic growth prospects and given the recent signs of strength in recent US economic data – especially the latest non-farm payrolls reading showing the US unemployment rate at a new 18-year low 3.8% and with average hourly earnings accelerating to 2.7% y-o-y – there is a very strong likelihood that the Fed will hike the Funds rate by 25bps to 2.00% at its policy meeting this month. The Fed is also likely to publish at the same meeting GDP growth and inflation forecasts at least as strong as those it produced in March. The Fed is likely to provide the bond market with strong reason to expect another one or two 25bps hikes in the Funds rate in the remainder of 2018 and at least three rate hikes in 2019. The outlook for Fed monetary policy moves and the evidence of renewed strength in the US economy point to high risk of renewed increases in US government bond yields.
As remarked last month Australian monetary policy is marching to a different beat compared to US monetary policy. The RBA left the cash rate at a record low 1.50% for a nineteenth consecutive month in early May. The subsequent quarterly Monetary Policy Statement although upbeat about growth prospects still implied no imminent pressure to hike the cash rate. Although Australian economic growth is improving there is still plenty of spare capacity to use up before there is a flicker of a higher inflation threat. Australia’s unemployment rate has been flat-lining over recent months around 5.5%, still a relatively high rate compared with just under 5.0% back in May 2011 and 4.0% in mid-2008 ahead of the global financial crisis. Most estimates place Australia’s current “full-employment” unemployment rate somewhere between 4.5% and 5.0%. In other words, Australia needs strong employment growth to continue to reduce the unemployment rate and place upward pressure on wages growth. Until there are signs of more growth in wages the RBA is reluctant to change the current very growth accommodating monetary policy setting.
The difference between steadily less growth-accommodating US monetary policy and continuing very growth-accommodating Australian monetary policy has led this year to an unusual and growing negative yield gap between Australia’s 10-year bond yield (2.67% at the end of May) and its equivalent maturity US bond counterpart (2.86%). There is a strong likelihood that gap will push beyond 50bps by the end of 2018. The loss of interest differential support for the Australian dollar seems likely to become much more pronounced potentially promoting bouts of weakness for the Australian dollar against the US dollar.
The RBA may need to face several issues as it tries to maintain very accommodative Australian monetary policy in the face of varying moves to normalise interest rate settings overseas. The first is the risk of a destabilised and much weaker Australian dollar exchange rate potentially lifting inflation faster and higher than the RBA is forecasting currently. A second issue is that low Australian interest rates again start to feed asset price inflation in parts of the Australian residential real estate market. A third issue is that households maintain higher levels of debt than are comfortably serviceable over the medium-to-longer term.
These are just few reasons why the RBA’s stated position that it will wait for wages to lift before hiking the cash rate is a high-risk position. Our view remains that the RBA will find enough cause in the data releases over the next few months to start hiking the cash rate in August or September.