Risk assets were mostly stronger through May, although the Australian share market was an exception, responding to softer commodity prices as well concern about local banks in the wake of the May Budget bank levy proposal. Outside Australia, the reflation trade enjoyed second wind assisted by signs that global economic growth was continuing although with a change of leadership from the US and China to Europe. Views in the market about the US monetary policy outlook were also shifting towards perhaps only one more 25bps hike this year rather than at least two touted by senior Fed officials earlier in the year. Most share markets gained ground in May ranging from 1.2% for the US S&P 500, which also made a new record high, to 4.4% for the British FTSE 100, where the market was expecting a strong win for Conservative Prime Minister Theresa May in the approaching general election. In Australia, the ASX 200 fell by 3.4% in May with the two biggest sectors banks and resource companies coming under selling pressure but for different reasons, an unexpected new tax and continuing concern around home lending in the case of the banks and a potentially softer growth outlook for China and commodity prices in the case of resource companies.
The Australian credit market was softer in May, partly in step with the softer local share market but also reflecting the continuing pressure on Australian banks, singled out for an additional tax in the Budget and with some smaller financial institutions coming under negative scrutiny by credit rating agencies. Government bond markets rallied in May assisted by changing views that the US Fed might be even slower hiking rates than expected previously. The US 10-year bond yield fell in May by 7bps to 2.21%, while the 30-year Treasury yield was down by 8bps to 2.87%. The Australian 10-year bond yield fell by more than its US counterpart, by 19bps in April to 2.38%.
Returning to factors influencing US financial markets, the economic readings have become mixed-strength. Housing activity still seems strong in surveys relating to homebuilders, but has a softer edge in the latest housing indicators with April permits and starts; existing home and new home sales; and pending home sales all falling. Some indicators of the labour market still point to tight conditions, the unemployment rate down to a decade low 4.3% in May and weekly initial jobless claims at times plumbing lowest (strongest) levels in more than 40 years. Yet non-farm payrolls were less impressive in both April, +174,000 and May, +138,000. Most other indicators of US economic activity are mixed strength too raising the issue of whether the Fed will hike the funds rate again at its mid-June policy meeting and if not then, when? Another complication assessing the US economic outlook remains how much of President Trump’s tax cuts and big spending proposed in his 2017 Budget will pass through Congress, a story that will evolve over the next few months.
In China, economic readings took a softer turn in April raising the issue of whether China’s growth rate will slide later in the year and below the Government’s aim of maintaining GDP growth of at least 6.5% y-o-y. The problem remains that sustaining relatively strong growth is at odds, at least in the near term, with reforming bank lending and containing excesses in residential property construction. Rebalancing China’s growth drivers with less emphasis on industrial production, exports and fixed asset investment spending, but more emphasis on retail sales and services remains a challenging and less than seamless exercise. The risk seemed to grow in May that GDP growth may slip more than the authorities would like later in 2017. It is also worth keeping in mind that China is still well placed to change tack and start priming economic growth again through easier monetary and fiscal settings if the need arises.
In Europe, economic readings continue to show signs of improvement and arguably Europe has started to increase its contribution to global economic growth. Q1 GDP growth at 0.5% q-o-q, 1.7% y-o-y was quite robust by its own standards and better than US economic growth and probably Australia too. Unemployment has started to fall quite rapidly, with the numbers unemployed falling by 233,000 in April after a 121,000 fall in March and taking the unemployment rate down to 9.3% in April and only 3.9% in Germany. Spending power is increasing in European households adding to improving sales and profits for many European companies. Importantly, Europe still has considerable spare economic capacity which means that the European Central Bank can maintain very easy monetary policy for at least the next year. Europe still faces political and economic challenges but they are starting to look more manageable with stronger economic growth helping to lift all boats.
The Australian economy is precariously balanced. The biggest headwind to Australian economic over the past few years, falling business investment spending, is fading fast. Private new capital expenditure rose by 0.3% q-o-q in Q1. At the same time the strongest supports for Australian growth over recent years, housing activity and household consumption are starting to fade. Tied to the fading strength of housing and household consumption spending, the household sector has borrowed to the limits of what can be considered prudent at a time of record low annual growth in wages. The financial regulatory authorities have tried to limit growth in lending for investment housing but in the process have added to banks’ costs causing a drift upwards in lending interest rates. The Government in its May Budget also decided to add to banks’ costs with a new tax which may show in higher lending interest rates too.
Predicting the local housing cycle has become very difficult, but the best outcome would seem to be a topping out which itself would mean that housing activity will contribute less to Australian growth than it has the past year or two. There are still some strong elements in Australia’s growth story, exports of goods and services notably. The RBA’s view is that the lumps and bumps in Australia’s growth rate will iron out over time with growth slowly accelerating above trend by late 2018. This scenario is possible and would mean that at some point higher wages growth and inflation would lead the RBA to start hiking the cash rate in 2018. It is also possible that the financial pressures in the household sector lead to a retrenchment of spending and economic growth slipping, the type of circumstances that would lead the RBA to lower its growth forecasts and cut the cash rate. We are not yet convinced that the weaker growth scenario is entrenched so for the time being we see the cash rate unchanged through the remainder of this year with a 25bps hike to 1.75% early in 2018. We are keeping this forecast under review waiting for more information to help determine whether Australian growth is likely to strengthen or falter later in 2017.