Risk assets were again mixed-strength through July although most markets remain near high points in the current cycle amid a growing view among analysts that although the drivers behind the current global economic recovery are changing, global growth in general is gathering pace. The strengthening global economic recovery is being recognized increasingly in the economic commentaries of the world’s central banks and is becoming a factor changing market views about the likely course of official interest rates and government bond yields. The Bank of Canada became the latest central bank to start lifting its cash rate in July. While the US Fed paused at its July policy meeting, it continues to provide guidance in speeches by senior officials that it will soon start reducing the size of its QE-bloated balance sheet and will deliver another 25bps hike to its funds rate by the end of the year. The RBA remains upbeat in its economic forecasts detailed in its early-August Monetary Policy Statement continuing to provide an unheeded warning signal to the Australian market that its next move is likely to be a rate hike, albeit not until 2018. Among share markets, the performance of the Australian ASX 200 was middle-of-the-pack and flat for the month. The US S&P 500 continued to make new record highs on favourable earnings reports and was up 1.9% in the month, while the weakest share market in July was the German DAX, down by 1.7%.
The Australian credit market was stronger in July and assisted by APRA providing certainty around future total bank capital adequacy ratios. The US Fed passed at its July policy meeting as widely expected but continues to indicate that it will start reducing the size of its balance sheet soon and that it is on track to hike the funds rate another 25bps by year-end. In a well heralded policy move, the Bank of Canada raised its policy rate by 25bps to 0.75%, its first tightening in 7 years and indicated more rate hikes are coming. The RBA left its cash rate unchanged at its early August policy meeting but was upbeat on the economy in its accompanying statement and in its subsequent quarterly Monetary Policy Statement. The US 10-year bond yield was unchanged in July at 2.30%, while the 30-year Treasury yield rose by 8bps to 2.91%. The Australian 10-year bond yield rose by by 8bps in June to 2.67%, building on the 21bps rise in June.
Returning to factors influencing US financial markets, the economic readings were on balance stronger through July and early August and point towards stronger US economic activity in the second half of 2017 supporting the Fed’s stated intentions to continue slowly and cautiously tightening monetary policy. US GDP growth strengthened to 2.6% annualised pace in Q2 from 1.2% in Q1. Growth in non-farm payrolls has strengthened noticeably in past two months up 209,000 in July after a revised gain of 231,000 in June. The unemployment rate was down to a 16-year low 4.3% in July. While the conditions for rising wages have been in place for many months there are signs that wages are starting to turn higher and that annual inflation will move above 2% y-o-y from later this year. The increasingly dysfunctional relationship between the Trump Administration and Congress is becoming a sideline issue as momentum in the US economy builds. The Fed has made it plain that it will continue to carefully adjust monetary policy tighter so that interest rates eventually become appropriate for an economy growing above potential placing upward pressure on inflation. The US bond market is still some way from accepting the Fed’s guidance implying a risk that bond yields could push higher, especially if data releases show signs of confirming the Fed’s economic forecasts.
In China, economic readings remained firmer-than-expected in July including the Q2 GDP release showing that annual growth continued at the elevated 6.9% y-o-y pace recorded in Q1. The authorities aim to achieve GDP growth of at least 6.5% y-o-y in 2017 and at this stage look set to meet this goal comfortably. The authorities still face a policy balancing act between the seemingly incompatible policy objectives of maintaining GDP growth at 6.5% y-o-y or higher while conducting reforms of banking and finance and state-owned enterprises that would normally be expected to slow economic growth for a period. Some run-down in residential property construction in the second half of 2017 is on the cards responding to policy tightening moves late in 2016 and early 2017. What weakness there is in residential construction is being offset by rising infrastructure spending in local government areas and firmer exports and retail spending. While the economic balancing act is still tricky in China it appears to be managing well so far. China also has greater capacity than any other major economy to ease fiscal and monetary policy settings in need and to direct those changes with greater immediate impact than in other countries too. China is well placed to meet its economic growth objectives and at this stage is helping to support global economic growth better than analysts expected at the beginning of this year.
Europe continues to be the stand out in terms of upside economic surprises. Annual GDP growth improved to 2.1% y-o-y in Q2 from 1.9% in Q1. The European unemployment rate continues to tumble down to 9.1% – a decade low reading- in June. Underlying annual inflation has cracked the 1% y-o-y mark and was up to 1.2% in July. Retail sales continue to rise strongly and were up another 0.5% m-o-m in June after lifting 0.4% in May. Concerns about adverse political developments have faded considerably, especially after the stunning electoral victories of centrist Emmanuel Macron and his party in France and the with the prospect much improved that European-ideal stalwart Angela Merkel will retain power comfortably in the approaching German elections. While there is no urgency for the European Central Bank to start lifting interest rates it is no longer looking to ease policy further.
The Australian economy appears to be taking a stronger turn and one that should be confirmed when the Q2 GDP report is released in early September. Employment growth has been noticeably stronger over recent months, up by more than 100,000 in the three months ending June and with full-time employment up by more than 110,000. This strong growth in employment should have underpinned strong growth in household disposable income in the quarter which helps to explain a turn (a very unexpected turn) higher in retail sales in Q2, up 1.5% q-o-q in real terms compared with a 0.2% gain in Q1. Household spending will make a much stronger contribution to GDP growth in Q2 than it did in Q1. Another positive change in contribution to GDP is likely to come from net exports that detracted 0.7 percentage points from growth in Q1, but are likely to provide a flat to slightly positive growth-contribution in Q2.
The Australian economy still faces potential headwinds. Household debt is precariously high and household budgets are extremely stretched. Housing activity is still likely to pull back and detract from growth over the next year or two. Growth in business investment spending is flat at best. Nevertheless, the RBA’s “glass half full” economic forecasts are starting to look realistic. Although inflation is still currently tame at 1.9% y-o-y in Q2 there are signs – rising energy prices, rising prices for manufactured goods and the increasing likelihood that wages growth will not stay quite as low as it has been – that inflation may climb in to 2-3% range from mid-2018 as the RBA is forecasting in its latest quarterly statement. If the RBA’s forecasts are accurate it is likely that that it will start hiking the cash rate in 2018. How far the cash rate might rise was illuminated by the academic discussion in the minutes of the July policy meeting about the neutral cash rate estimated to be around 3.50%. As the RBA was quick to point out the neutral rate discussion was not a forecast of the cash rate as so many factors can influence the neutral rate, not least the relative strength of the Australian dollar exchange rate. Nevertheless, if the Australian economy is growing above potential with inflation rising through the RBA’s target band by late 2018 as the RBA is forecasting the cash rate will conservatively need to be around 100bps higher than the current 1.50% by the end of 2018.
On balance, our view of Australian economic growth over the next year or so has continued to firm based on data released over the past month. We still see the cash rate unchanged through the remainder of this year with a 25bps hike to 1.75% early in 2018. We continue to keep this forecast under review waiting for more information to help determine whether Australian growth is likely to strengthen or falter later in 2017. More importantly, we have firmed our view that there are likely to be four cash rate hikes next year taking the cash rate to 2.50% by the end of 2018.