Is the long global economic recovery ending and with it the long bull market in shares and most other assets including residential real estate? Is inflation coming back to life helping to kill the era of super-low interest rates and turning a possible economic downturn in to a period of stagflation? These questions have become more prominent in the minds of investors after a week that saw hefty falls in share markets (albeit with a strong rebound on Friday) and the US 10-year bond yield push-up to its highest level since 2011. Scanning the calendar of global and local economic news over the next month or two and likely outcomes the fears that swirled through financial markets over the past week or so look premature.
On our watch list through to Christmas are Q3 GDP reports and various labour market and inflation readings. We expect that GDP growth held up quite well in Q3 in the world’s biggest economies generating good jobs growth and low or very low unemployment rates. Wages growth continued to lift in some economies, notably the United States, China, Germany and Japan. Business profit growth would have been very well supported in these economic conditions (the Q3 US company profit reporting season starts this week and is likely to show many positive surprises even if earnings forecasts hold a few more warnings).
The first major Q3 GDP report will be issued by China later this week and looks set to come in at a respectably strong 6.6% y-o-y only a touch lower than 6.7% reported in Q2. Any weakness in China’s export growth (up 14.5% y-o-y in September from 9.8% in August) resulting from US trade restrictions still lies several months in the future and other key components of China’s GDP growth are holding up well, even accelerating in the case of retail spending.
The first reading of Q3 US GDP growth will be published later this month and notwithstanding severe weather events looks set to come in above 3% annualised pace helped by strong household and business spending. An above 3% GDP result would consolidate the unusually strong 4.2% annualised lift in Q2 and provide strong growth momentum in Q4 and heading in to 2019. Germany and Japan report Q3 GDP a little later than the US are both likely to show slightly stronger GDP growth than reported in Q2.
Australia will report Q3 GDP much later still on 5th December and looks set to report a third consecutive quarter of above 3% y-o-y growth. Very strong employment growth is combining with low but improving annual wages growth to boost growth in household disposable income underpinning the best annual growth in retail spending for two years. Business investment spending and Government infrastructure spending are ramping up. Export growth has been very strong and is encouraging renewed investment spending in the sector. Softer housing spending and the drought in the eastern states will generate some headwind to growth, but the negative influence is comparatively small relative to the positive factors driving growth.
We expect GDP growth reports over the next two months and much of the partial data relating to them to be consistent with strong global economic growth. The strength of the economic data reports should help to prevent too negative a view developing in major share markets and markets for other assets too.
The potential spoiler of good economic growth news is any evidence of an untoward lift in inflation causing too large a lift in interest rates. The US economy is closest potentially to a lift in inflation. Strong growth has used up excess capacity in the labour market. Reports of difficulties obtaining labour are becoming more common. Although wages growth has accelerated in the US it is still not at the point of adding to inflation mostly because labour productivity has been improving too. Average hourly earnings rose 2.8% y-o-y in September and will almost certainly push above 3% y-o-y over the next few months. However, labour productivity recorded 2.9% annualised change in Q2. Unit labour costs in the US actually fell by close to1% in Q2.
The trade war increasingly between the US and China has the potential to lift prices in the US and it will matter whether the Federal Reserve views the price changes as one-time or likely to lift “inflation expectations” more permanently. Despite recent references to inflation expectations we expect that the Fed will avoid trying to link future policy moves explicitly to changing inflation expectations largely because inflation expectations are virtually impossible to measure with any confidence.
We expect the Fed to continue to link future monetary policy moves to the recent track of measured inflation and inflationary pressures such as wages growth. US inflation has lifted, but only modestly. The CPI measures of annual inflation are running a little above 2% y-o-y while the Fed’s preferred deflator measures are still running below 2%. The Fed has cause to continue lifting the Funds rate (currently 2-2.25%), but on a gradual trajectory and probably to a peak not much above 3%.
Based on our views about Fed policy the sharp move upwards in the US 10-year bond yield above 3.25% last week looks like an overshoot. On our watch list, however, are the discussion in the minutes of the last Fed policy meeting due later this week. A “data-watching” Fed plays to our view of only gradual Fed tightening, but a Fed becoming more fixated on inflation expectations runs greater risk of lifting interest rates too quickly and potentially too high.
At home we are watching the September labour force report on Thursday to provide another signal of strong growth. The Q3 CPI towards the end of the month is likely to show inflation a little higher than the RBA is forecasting, about 2.1% y-o-y. The quarterly RBA Monetary Policy Statement on 9th November may need to recognise that Australian GDP growth and inflation are likely to be a little higher than previously forecast by the RBA in 2018 and 2019. Our watch list indicates a very low likelihood of stagflation developing. Rather a period of quite strong GDP growth with mild lift in inflation lies in store, at least over the remainder of 2018 and probably extending in to early 2019.