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Weekly update: Trade war risks recede but shares remain messy
Economy and markets|Author Shane Oliver
29 March 2018
Investment markets and key developments over the past week

Share markets had another messy week with an early bounce as investors realised that trade war fears were overstated but concerns about restrictions on Chinese investment in US tech stocks, a regulatory response to Facebook’s privacy breach and a continuing rise in bank funding costs all weighing on shares. This saw US, Eurozone and Japanese shares up a bit but Chinese and Australian shares down. The hit from trade war fears, Facebook and funding cost increases on the back of Fed worries saw the correction that got underway in February continue in March with most major share markets, including the Australian share market down 4% or so in March. Safe haven demand saw bond yields slip a bit further over the last week and commodity prices were mixed with oil, gold and iron ore down but metals up. The $US rose and this saw the $A fall.

The initial response to President Trump’s proposed tariffs on China was an overreaction with US shares losing $US1.4trn in market cap in response to maybe less than $50bn in tariffs on a tiny fraction of global trade in a year when the US will see something like $US800bn in fiscal stimulus this year. Our view remains that China and the US will reach a negotiated solution both in terms of trade and investment restrictions such that the tariffs and restrictions will ultimately be very modest, if at all. But this could take a month or more to resolve and so market nervousness around this issue will linger for a while.

US bank funding costs are still blowing out, with a flow on to Australia – but it’s not a GFC re-run. The gap between US dollar interbank lending rates and the expected Fed Funds rate has continued to widen raising concern about some sort of credit crunch. This has also had some flow on to Australia with the gap between 3-month bank bill rates and the expected cash rate also widening to over 0.5% with the bank bill rate currently around levels consistent with a 2% cash rate. The longer this goes on the greater the hit to bank margins and the greater the risk of a rise in variable mortgage rates (which would be more likely for investors than owner occupiers given the bad publicity this would cause with the Banking Royal Commission underway). However, it is minor compared to what occurred at the time of the GFC and it does not does not reflect banking and credit stresses. Rather the drivers have been increased US Treasury borrowing after the lifting of the debt ceiling and US companies repatriating funds due to tax reform. So it should settle down – but it’s worth keeping an eye on until it does.

Is the FAANG bubble over? Tech stocks remained under pressure over the last week led by Facebook on the back of its privacy violation along with worries about a broader regulatory response for e-commerce stocks and concerns the Trump Administration will limit Chinese investment into tech stocks. Tech stocks have been at the forefront of the US bull market and some worry that a bubble in FAANG stocks has come to an end. Tech shares have certainly had a long run up and have been a key beneficiary of quantitative easing. As such they are vulnerable to a likely tightening in regulation and quantitative tightening and we think there are better opportunities to be had in value stocks that have been relative underperformers. However, while the run- up in FAANG stocks in recent years does look a bit bubbly its nowhere near the scale of the late 1990s tech boom – see the next chart.

And the forward PE on tech stocks today is well below what it was at the height of the tech bubble and has been more in line with that of the overall market.

While we expect the tailwind from falling bond yields as a driver of unlisted commercial property and infrastructure returns to start to fade this year, parts of unlisted commercial property are seeing the typical boost that they get in this stage of the cycle from rising rents. This is clearly evident in the Sydney office market with prime effective rents pushing above $1000 m2 for the first time and effective rents in the Melbourne CBD up 13% year on year as vacancy rates fall.

And on Easter Sunday just watch the chocolate eggs…Athlete’s Foot pointed out that a 100g chocolate Easter egg has 538 calories – which will take a 60-minute run to burn up!

Major global economic events and implications

US data was mixed over the last week. Consumer confidence fell slightly in March but remains very high, pending home sales rose in February and home prices continue to rise solidly and December quarter GDP growth was revised up to 2.9% annualised thanks to more consumer spending. Against this the goods trade deficit worsened slightly further and some regional manufacturing conditions indexes slowed.

Eurozone economic sentiment slipped in March, as business sentiment fell slightly but it remains very high.

Chinese industrial profits accelerated in January/February to growth of 16% year on year providing more evidence that Chinese growth has held up at the start of the year.

Australian economic events and implications

In Australia, job vacancies remained very strong in February according to the ABS consistent with various private surveys in continuing to point to ongoing strong jobs growth. Meanwhile, credit growth remains moderate with housing investor credit continuing to slow. A tightening in bank lending standards around borrower income and expenses could lead to a further slowing in credit growth ahead.

What to watch over the next week?

In the US, the main focus will be on March jobs data to be released Friday which is expected to show a solid 190,000 gain in payrolls, a fall in unemployment to 4% and a bounce back in wages growth to 2.8% year on year maintaining the gradual accelerating trend seen over the last few years. In other data, expect to see slight falls but to still very strong readings of around 59 in the March manufacturing conditions ISM (Monday) and non-manufacturing ISM (Wednesday) and a further slight worsening in the February trade deficit (Thursday).

Eurozone core inflation for March is expected to edge up slightly to 1.1% year on year and unemployment is expected to fall further to 8.5% with both due Wednesday. Neither will be enough to speed the ECB up towards an exit from easy money.

The Tankan business survey in Japan (Monday) is likely to show strong conditions consistent with ongoing good growth.

In China, the Caixin business conditions PMIs will be released.

In Australia, the Reserve Bank (Tuesday) is likely to leave rates on hold for the 20th month in a row, which will surpass the previous record of 19 months on hold which was set between January 1995 and July 1996. High business confidence, strong jobs growth and the RBA's own growth and inflation forecasts argue against a rate cut, but risks around consumer spending, weak wages growth and inflation, the slowing Sydney and Melbourne property markets and the still too high $A argue against a rate hike. We don’t see the RBA commencing a tightening cycle until first half 2019 and an emerging further tightening in bank lending standards around home borrower income and expenses along with any flow through to higher mortgage rates from the recent increase in short term funding costs could delay this.

Meanwhile on the data front in Australia, expect CoreLogic data for March to show continuing flat to slightly falling home prices (Tuesday), a 12% or so fall in building approvals in February after a 17% spike in January and a 0.3% gain in February retail sales (both due Wednesday) and a February trade surplus of around $900m (Thursday). Business conditions PMIs for March are likely to remain solid. 

Outlook for markets

Volatility in share markets is likely to remain high and further weakness is possible as US inflation and interest rates move up and as issues around President Trump and trade continue to impact particularly ahead of the US mid-term elections in November, but the medium-term trend in share markets is likely to remain up as global recession is unlikely and earnings growth remains strong globally and solid in Australia. We continue to expect the ASX 200 to reach 6300 by end 2018 – it might just take a bit longer to get back on the path up to there.

Low yields and capital losses from rising bond yields are likely to drive low returns from bonds.

Unlisted commercial property and infrastructure are still likely to benefit from the search for yield by investors, but it is waning, and listed variants remain vulnerable to rising bond yields.

National capital city residential property price gains are expected to slow to around zero as the air continues to come out of the Sydney and Melbourne property boom and prices fall by around 5%, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.

The $A is likely to fall further as the gap between the RBA’s cash rate and the US Fed Funds rate pushes further into negative territory. Solid commodity prices should provide a floor for the $A though – in contrast to early last decade when the interest rate gap was negative and the $A fell below $US0.50.