Risk assets had a bumpier ride through April buffeted by rising geopolitical risks, a key election in France, the calling of a British election to smooth the way for formal divorce negotiations from the EU and a flurry of mostly softer economic readings from the US. In Australia, economic readings were mixed-strength and the complex issue surrounding housing came to the forefront of political discussion while financial regulators continued to batten down on perceived excesses in lending to residential property investors. The post US election reflation trade seemed all but over early in April, but gained second wind late in the month assisted by a market-friendly French election result and a view developing in interest rate markets that the Fed may hike only once more in 2017, rather than twice as senior Fed officials continued to indicate. Among major share markets the best gain during the month came from the Eurostoxx 50, up by 1.7%. Most other share markets made gains around 1%, including the Australian ASX 200, up 1.1%. The British FTSE 100 was an exception, down by 1.6% and beset by a noticeably stronger British pound exchange rate after British Prime Minister, Theresa May, called an election for early June which she is expected to win comfortably smoothing the way for Britain’s divorce negotiations with the EU over the next two years.
Credit markets, after wobbling with share markets early in April also regained strength later in the month allowing credit spreads to narrow a touch over the month. Government bond markets were more volatile during April but still rallied over the month amid a developing view that the US Fed might slow its plan to lift its funds rate twice more in 2017 because of potential weakness in the US economy. Interestingly, most senior Fed officials, including Chairman Janet Yellen continued to reaffirm that it would be unwise to delay lifting US interest rates for too long implying another 25bps rate hike at either the May or June policy meetings. The US 10-year bond yield fell in April by 11bps to 2.28%, while the 30-year Treasury yield was down by 6bps to 2.95%. The Australian 10-year bond yield fell by 12bps in April to 2.57%.
Returning to factors influencing US financial markets, many US economic readings took a softer turn in March and Q1 2016. The Q1 GDP reading highlighted how mixed-strength the US economy has become. Annualised GDP growth was only 0.7% well down from 2.1% in Q4 2016. Consumption spending was very soft, lifting only 0.3% annualised in Q1, the weakest reading since Q4 2009 in the middle of the last recession. In contrast, residential investment spending was very strong, +13.7% annualised, and so too was non-residential investment spending, +9.4% annualised. It is possible that consumption and GDP weakness in Q1 was weather-related because of the unusually late severe winter storms in March. Whatever the reason for the weakness it complicates the economic outlook for the US Fed facing increasing evidence that labour market conditions are tightening threatening higher inflation down the track, as well as watching progress of the Administration’s proposed substantial and stimulatory tax cuts. It still seems likely to us that the Fed will deliver two more 25bps rate hikes this year, but with the next instalment unlikely until the early June policy meeting allowing time to assess April and May economic data.
In China, economic readings took a firmer turn in March and in Q1 with GDP growth lifting marginally to 6.9% y-o-y from 6.8% in Q4 2016. The strength in China was broad-based late in Q1 including better-than-expected March growth in exports, industrial production, urban fixed asset investment, and consumer spending. The Peoples’ Bank of China continues to gently edge up some of its key lending interest rates while China’s government continues to pursue policies that risk growth in the near-term – reforms to banking and state-owned enterprises – but also promise more sustainable economic expansion over the medium-to-longer term. It is a very delicate balancing of economic policies, but one that seems less likely to dent near-term growth too much, a fear that is becoming less widely held in financial markets. Developments in North Korea also need to be closely watched regarding China and its relationship with the US and its allies such as Japan and Australia. Possible sharp disruption to China’s international trading relationships and a major downside risk to global growth is a small but growing possibility as North Korean/US brinkmanship threatens to become a military conflict.
In Europe, economic readings continue to show signs of improvement and Europe’s unemployment rate has fallen to 9.5%, the lowest reading in nearly a decade. The first round victory in the French presidential election by moderate, pro-EU and pro-immigration candidate, Macron, helped to allay substantially a fear that a break-up of the EU and the European currency could occur as anti-establishment, populist politicians seize power in various elections across Europe. The run-off French presidential election early in May is expected to confirm Macron has won the French presidency. In Britain, after starting the two-year process of divorce from Europe, Prime Minister May has called an early election for June to provide a mandate to negotiate Brexit terms efficiently and be in power to preside over the early period after the divorce takes effect in 2019. Early opinion polls point to the conservatives being returned to government with a much bigger majority. The greater certainty around Brexit negotiations has caused the British pound to lift sharply, taking away some of the competitive advantage for British businesses from the weakness of the pound since the Brexit referendum decision.
The Australian economy is showing signs of erratic improvement, but the two biggest contributors to the improvement, strong exports and housing activity both have a rather cloudy future. Rising exports have been driven mostly by improving global growth especially still quite strong growth in our biggest export market China. Demand still looks good near-term although Australian export supply is temporarily disrupted by weather damage to key transport infrastructure in Queensland and Western Australia. One longer-term uncertainty surrounding export growth is how much China’s growth rate slows later in 2017, possibly not too much at this stage. Another potentially much bigger disruptor of Australian exports is a potential military conflict on the Korean peninsula. Hopefully, the likelihood of a conflict is still very small. But it would severely reduce Australian exports if it occurs.
As far as housing activity is concerned, it has been strong but progressing to the point of being too strong in parts threatening to generate pockets of too much new housing supply while at the same time generating excessive upward price pressure in Melbourne and Sydney severely distorting rational investment decision making in the household sector, generating dangerously high levels of household debt, and potentially threatening a home-grown Australian financial crisis down the track. Australian financial regulators have been steadily working to cap the housing boom over many months by try to ration and change the relative interest cost of investment home loans. Calling a top on home buying activity is always tricky but it may have occurred in April. The financial regulators are likely to maintain pressure to ensure that there is no resurgence in home prices for a considerable period. At this stage it is unlikely that the RBA will need to add to the efforts of the financial regulators, although evidence that Australian inflation has based in the Q1 readings of the CPI and producer prices imply that the next cash rate move will be a rate hike although probably not until early 2018.