A mix of small gains and losses characterised the trading fortunes of most major share markets in June although with standouts on positive side for the Australian ASX 200, up by 3.0% in the month and on the negative side the German Dax, down by 2.4%. The out-performance of the Australian share market during June came down to a strong performance by resource stocks assisted on the back of higher commodity prices assisted by bargain hunting buying among bank shares thoroughly belted in April and May by revelations from the Banking Royal Commission. The weakness of the German share market in June came down mostly to growing concern that higher US tariffs aimed at a wider range of European exports could harm major exporter Germany more than most.
The performance of the US S&P 500 was also worth noting during the month. It was up a seemingly unremarkable 0.5% in June but masking within month turmoil from a much bigger gain early in the month to giving up almost all the improvement in the second half. There was a sense that investors are starting to question whether the long bull run in the US share market is coming to an end. While the US economy is still looking strong, the global economic growth outlook is starting to look less robust.
The trade war initiated by President Trump escalated in June and threatens to dampen global economic growth prospects. Central banks are in the process of withdrawing the monetary stimulus that has helped prime growth over the past decade. The European Central Bank announced in June that it would step down quantitative easing in September and end it in December. The Bank of England at its policy meeting in June made it much clearer that it is close to starting to lift official interest rates.
The US Federal Reserve (Fed), the one central bank that is well along the path of normalising interest rates announced a further instalment at its June policy meeting, hiking its Funds rate by 25bps to 2.00%. Importantly, in the announcement accompanying the rate hike the wording implied strongly that the Fed would be a touch more aggressive in its future rate hiking program. The dot point forecasts of the future Funds rate provided by the Fed district presidents indicated another two rate hikes in the second half of 2018 rather than one forecast previously.
The wariness in share market trading also showed in credit markets in June. The problem areas in the sovereign credit risk market such as Italy and emerging markets remained under pressure. Australian credit was also softer with spreads widening and notwithstanding the improving turn in the fortunes of bank shares during the month.
After rallying in May, Australian and US government bond yields were relatively stable in June although in the case of the US shorter-dated bond yields rose a touch influenced by the hike in the Fed Funds rate while long-term Treasury yields fell (the 10-year yield was flat over the month at 2.86% while the 30-year yield fell by 4 basis points to 2.99%). The noticeable flattening of the US bond yield curve over recent months points to a growing disconnect between the market view that US interest rates cannot rise too much further without cutting in to US growth prospects and the Fed’s view that the US economy is growing beyond its potential, threatening higher inflation and needing interest rates to rise above 3% over the next year or so. In the near-term, the relative strength of key US economic readings, especially those relating to the tightness of the labour market and the outlook for wages growth and inflation are likely to arbitrate between the differing views of the US bond market and the Fed. Based on recent surveys showing considerable pipeline inflation pressure building in the US, the risk is firmly on the side that these key readings will show higher inflation. The risk is very high of a jolt upwards in US bond yields.
As remarked over recent months 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% in early June and in public comments continues to point to the prolonged period of cash rate stability persisting even as more central banks overseas start to move towards reducing monetary accommodation. The RBA’s steady cash rate view is anchored by a benign inflation outlook where very low wages growth is slow to lift and annual inflation creeps up in to the lower part of the RBA’s 2-3% target range later next year.
One factor that needs to be kept in mind is that the 1.50% cash rate, in some respects, has become a more growth accommodating interest rate over the past year in the sense of its impact promoting a weaker Australian dollar exchange rate. Also, in real terms the cash rate has fallen over the past year as inflation has risen a little. Australian economic growth has accelerated and is running above long-term trend; employment growth is exceptionally strong; and the unemployment has fallen a little nationally, but more noticeably in New South Wales and Victoria. If these trends continue (increasingly likely with an extraordinarily low interest rate settings and a depreciating currency), wages growth and inflation will not gradually edge up but more likely will lift sharply as a wider range of sectors in the economy experience difficulties obtaining labour.
For the time being, the Australian Government bond market is running with the RBA’s view of the cash rate staying lower for longer. In June, the 10-year bond fell by 4bps to 2.63%, trading 23bps below its US equivalent. Over the next few months the US Fed will tighten probably twice more at least before the RBA starts to lift rates. The negative spread between the Australian 10-year bond yield and the US 10-year bond yield is likely to widen to at least 50bps over the next few months.
Our view is that higher wages growth and inflation will show through comparatively soon in Australia, forcing the RBA to start hiking the cash rate later this year. In one sense, the timing of the first cash rate hike is becoming less important for Australian borrowers. Rising interest rates in the US has placed upward pressure on the offshore borrowing costs of Australian banks. Arguably higher US interest rates has also been a factor in driving upwards short-term money market interest rates in Australia too. Australian banks have suffered over recent months the order of upward pressure on their borrowing costs that would in the past have occurred after at least one 25bps RBA rate hike. Australian borrowers are starting to suffer a “Clayton’s” rate hike.