Risk assets mostly strengthened in December capping off a strong year. The reason for the strength in December was much the same as it has been for much of 2017, more signs of broadening and quickening global economic growth, still comparatively low inflation and interest rates, and central banks removing monetary accommodation very cautiously. In addition, in the United States, the most extensive tax cuts in 30 years became law and in the United Kingdom the beginnings of a deal on Brexit terms with the EU started to emerge. Among major share markets, the best gain in December came from Britain’s FTSE 100, up 4.9%. The US S&P 500 gained 1.0% and touched record high points several times through the month. Australia’s ASX 200 had a good month and finished December up by 1.6% and at a 10-year high. Continental European share markets bucked the improving trend in December and the Eurostoxx50 fell by 1.8%.
Australian credit rallied further in December as investors continued to seek out yield in a world where strong economic growth and fast rising company earnings seemed to diminish risk. As was the case the month before the biggest potential threat to the long rally in risk assets is when strong global growth eventually spills over to higher inflation causing central banks to tighten monetary policy settings more aggressively. There were still no signs in December of a strong lift in inflation that might force central banks to tighten policy more aggressively. The US Federal Reserve (Fed) increased its funds rate by 25bps to 1.50% as widely expected, but still indicated an unchanged game plan to deliver another three rate hikes in 2018. The RBA finished the year where it started with its cash rate unchanged at a record low 1.50% and with comments that indicate it is in no hurry to raise rates even though on balance the economy is showing signs of strengthening. The US 10-year bond yield was unchanged in December at 2.41% and was 3bps lower than at the end of December 2016. The US 30-year Treasury yield fell by 9bps to 2.74% causing the already very flat US bond yield curve to become even flatter. The 30-year Treasury yield finished 2017 33bps lower than where it finished 2016. In contrast to the strength of US bonds, the Australian 10-year bond yield rose by 14bps to 2.63%, but that was still 13bps lower than where it finished 2016.
The main positive influence on US financial markets through December and for that matter most of 2017 has been evidence of strong US and global economic growth boosting the earnings of US companies. Q4 US GDP will not be available until later this month, but is likely to show annualised growth above 3% (Q3 was 3.2%) rounding out a year of above potential economic growth that has seen the US unemployment rate fall to a 16-year low 4.1%, the beginnings of a general lift in wages and strong spending by US households and businesses. US economic data and surveys released through December and early January show signs that the strong pace of economic growth is being maintained. November housing readings were especially strong with housing starts up 3.3% m-o-m, and new home sales up 17.5% m-o-m! November retail sales were strong too, up by 0.8% m-o-m, and with a core reading excluding automobile sales, up 1.0% m-o-m. December business surveys point to a continuing expansion in activity with the manufacturing ISM (Institute of Supply Management) lifting unexpectedly to 59.7 from an already strong 58.2 in November. The non-manufacturing (services sector) ISM was not quite so strong, settling back to 55.9 from 57.4 but is still tracking in expansionary territory (any reading above 50).
Importantly, the strength of the US economy is still occurring without untoward upward pressure on US inflation. Headline CPI inflation was 2.2% y-o-y in November, but core inflation (excluding food and energy prices) was still a relatively low 1.7% y-o-y. The members of the US Federal Reserve’s monetary policy committee (FOMC) continue to actively debate when strong growth and the tight US labour market will promote higher inflation but the balance of opinion among voting FOMC members remains that there is no urgency requiring a faster pace of monetary policy tightening than has already been heralded. At some point, if US economic growth continues above trend as seems likely, the US Fed will probably move to tighten monetary policy at a quicker-than-heralded pace. That may be the point when risk assets suffer a pronounced set-back.
Another theme through 2017 that continued in December was the broadening global economic recovery. China was an important part of that theme because its economic growth rate did not moderate as much many analysts feared at the beginning of 2017. China was deemed to be a country with increasing economic management problems in 2017 where urgent economic reforms were likely to crimp GDP growth. In the event, China’s economic authorities embarked on a significant range of reforms but without compromising top-line GDP growth to any extent. China’s Q4 GDP growth rate is due to be released next week and seems likely to come in around 6.8% y-o-y, the same as in Q3 and only a fraction less than 6.9% y-o-y recorded in Q2 and Q1. One issue is whether President Xi views the strength of the economy through 2017 as an opportunity to accelerate economic reforms in 2018 which may still cause GDP growth to moderate. Even if President Xi pursues greater economic reforms the strong momentum in global economic growth is likely to prevent China’s GDP growth moderating too much.
Europe provided the biggest positive surprise through 2017 and although there is some concern among analysts that GDP growth momentum will fade in 2018, there are very few signs that any fade is on the cards in the near term. Q4 GDP will not be released for another month, but it is shaping up around 2.6% y-o-y, similar to Q3 GDP growth. Most indicators of European economic activity released in December were stronger than expected, especially surveys of European businesses and consumers. European inflation remains very well contained, 1.4% y-o-y in December with the core reading steady at 0.9% y-o-y. Low inflation and a touch of uncertainty about Europe’s growth outlook continues to sideline the European Central Bank. At its December meeting it left policy unchanged and even though there was some dissension among members of the policy committee the essential message is that asset purchases, albeit at a lower rate commencing this month, will continue through to at least the end of September and the very low -0.40% official deposit rate is unlikely to be changed this year. European monetary policy is still very growth accommodating and looks set to remain growth accommodating for many months.
In Australia, annual GDP growth accelerated to 2.8% y-o-y in Q3 from 1.9% in Q2 and more importantly show signs of much stronger domestic spending driven by another quarter of very strong engineering construction spending. Growth in household consumption spending was relatively soft in Q3 and household spending generally remains a potential Achille’s heal for the Australian economy. Extremely high household debt, a legacy of the earlier housing boom through to mid-2017, is compromising the ability of households to spend. Other factors that might encourage households to spend more are mixed-strength. On the negative side house prices are no longer rising and look set to fall through 2018 capping growth in household wealth. Wages growth is still weak sitting around 2.0% y-o-y. On the positive side, employment growth is very strong, up 61,600 in the latest reading for November and driving the strongest annual growth in employment in more than two decades. The unemployment rate has fallen to a four-year low 5.4%. The Government is heralding possible income tax cuts in its May Budget. On balance, it is likely that households will find more reason to become optimistic rather than less over coming months consistent with the RBA’s view that economic growth will gain momentum this year.
The RBA is waiting to see if the economic growth quickens before it considers changing monetary policy. Other factors that the RBA is watching include when the tightening labour market spills over in to stronger wages growth. It is also watching inflation, although so far inflation has been very low and still sits below the RBA’s 2-3% target band. The RBA still seems comfortable leaving the cash rate unchanged at 1.50% for several more months although in a growing economy there is some risk that leaving the cash rate so low may prompt households to become even more heavily indebted risking a much more pronounced retrenchment of household spending at some point in the future and a retrenchment that may plummet the economy in to recession. Increasingly, the RBA is entering a phase of what will cause it least regret – leave the cash rate low with a high probability of helping to foster a deep recession at some point, or lifting rates and prompting softer near-term growth but with household balance sheets in a better position in the future ameliorating the risk of a deep recession down the track. We suspect that wages and inflation will move higher around mid-2018 and could be the deciding factor helping to shift the RBA towards hiking rates with a first 25bps cash rate hike to 1.75% probably in August or September 2018.