Risk assets rose strongly in October amid further signs that global economic growth is gathering pace and assisted by still relatively low interest rates. Although central banks continued to move away from extremely growth accommodating policy settings they continued to provide signs that the process would be very cautious. The favourable factors underpinning the rally in risk assets outweighed still pronounced geopolitical concerns. Among major share markets, the best gain in October came from Japan’s Nikkei, up 8.1% and the smallest improvement came from Britain’s FTSE 100, up 1.6%. The US S&P 500 rose by 2.2% and repeatedly made record highs through the month. Australia’s ASX 200 performed comparatively well and was up 4.0% taking the index to a two-year high.
The Australian credit market rallied strongly in October assisted by investors seeking out any value in risk assets. A key factor assisting risk assets in general is that global economic growth is building momentum, but without untoward upward pressure on inflation to this point that might prompt central banks to tighten policy at other than very cautious pace. The US Federal Reserve (Fed) left its funds rate unchanged at its October 31st/ November 1st meeting but was still upbeat on US growth prospects implying that its previous guidance on rates is still current – another 25bps hike to 1.50% at its mid-December meeting and three more hikes in 2018. The European Central Bank announced a reduction in its QE purchases but not beginning until 2018 and with QE still likely to be in place through next year. The RBA continues to hold its cash rate at a record low 1.50% and with mixed-strength Australian economic readings is in no hurry to start lifting rates. The US 10-year bond yield rose by a modest 5bps in October to 2.38% and the 30-year Treasury yield rose by even less, by 2bps to 2.88%. In contrast, the Australian 10-year bond yield fell by by 14bps in October to 2.69%, reflecting in part that RBA comments were less dovish through the month than those from US Fed officials.
The main positive influence on US financial markets through the month was more evidence of strong US and global economic growth boosting the earnings of US companies. Despite growth-crimping severe US weather events in September, Q3 GDP grew at an above trend 3.0% annualised pace only a fraction short of the 3.1% pace recorded in Q2. Various US indicators point to strong US growth continuing with consumer and business sentiment readings running near record highs and the US unemployment rate down to 4.1% in October the lowest reading since the beginning of the century. Adding to positive influences President Trump’s 2018 Budget was passed by Congress, some tax reform seems to be coming and the President’s choice of Jerome Powell to take over the Fed reins from Janet Yellen is widely viewed as providing the best option for continuity of Fed policymaking. At some point, US inflation is likely to accelerate requiring the Fed to tighten monetary policy more aggressively, but until that time arrives conditions remain favourable for investors in US risk assets.
In China, Q3 GDP growth slipped fractionally in Q3 to 6.8% y-o-y from 6.9% in both Q1 and Q2, but is stronger than forecasts earlier in the year by most analysts of a second-half slowdown. The costs to China’s GDP growth rate of re-ordering the drivers of growth away from excessive residential construction and heavy manufacturing and more towards faster consumer spending and output of services are less onerous than expected so far. Much more economic reform still needs to occur and President Xi outlined his plans for the next five years at the Communist Party Conference in October. China will remain a centrally controlled economy and the influence of the Communist Party and its leader will be strengthened. China’s model of economic development will remain suspect from the point of view of pro free market western analysts, but for the time being those doubts are being allayed by evidence that China continues to grow better than most would have considered possible earlier in the year.
Europe is becoming an increasingly important engine of global growth in 2017. Europe’s GDP growth rate continues to improve and the preliminary reading of annual GDP growth in Q3 showed acceleration to an above trend 2.5% y-o-y from 2.1% in Q2. Europe’s unemployment rate continues to tumble down to 8.9% in September from 9.0% in August and leading indicators of business and consumer spending point to a further lift in spending over coming months. The ECB remains comparatively cautious. At its October policy meeting it decided to reduce its monthly purchase of bonds (QE) from 60 billion euro a month to 30 billion, but not commencing until January 2018. The ECB also reaffirmed that QE purchases would continue until at least September 2018 a sign that the ECB’s ultra-low interest rate settings will not be raised over the next year. Strong economic growth and extremely low interest rates are attracting investors to seek comparative value in European risk assets. The UK’s Brexit negotiations plus a first 25bps interest rate hike from the Bank of England in October dilute the relative attractiveness to investors of British risk assets.
In Australia, economic growth prospects are more mixed than elsewhere. Parts of the economy are strengthening. Employment growth in 2017 so far is the best it has been in more than 15 years and the unemployment rate is down to a 4-year low of 5.5%. Exports of goods and services are rising strongly. There are pockets of big infrastructure building under way, especially in the eastern states. The long slump in business investment spending appears to be over. Set against these positive influences, housing activity, a strong contributor to growth in 2015 and 2017 is starting to present a headwind to growth in 2017 and one that may intensify next year. Household consumption spending is becoming anemic beset by low wages growth, high household debt, and increasing concern about the future because of a perception that Government is caught in a prolonged phase of weakness and policy-making inertia. On balance, GDP growth should improve, but not as much as overseas.
Comparatively modest improvement in Australian economic growth and still with only modest inflation leaves the RBA to continue doing what it has done for more than year – leave the cash rate unchanged at a record 1.50%. Leaving the cash rate at 1.50% is also unlikely to unsettle the heavily indebted household sector. The problem is that leaving the cash rate so low may also 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 some lift in inflation over coming quarters may be the deciding factor helping to shift the RBA towards hiking rates with a first 25bps cash rate hike to 1.75% still likely in February or March 2018. We also expect the RBA to follow up with another two rate hikes later in 2018 taking the cash rate up to 2.25% by the end of the year.