Since our last weekly update three weeks ago, investment markets have been on a bit of a roller coaster ride, with Santa missing Christmas for markets, but arriving the day after.
Global shares, led by the US, continued to plunge into Christmas as the partial government shutdown started, taking the decline in US shares to 19.8% from its September high.
However, since Christmas share markets have rebounded, credit spreads have narrowed and the $US has fallen as investors have become a bit less nervous about the outlook.
This has been helped by a more dovish US Federal Reserve (Fed), signs of progress on the US/China trade conflict and maybe a bit of Christmas/New Year cheer.
The past week has seen shares continue to rally, with US shares up 2.5%, Eurozone shares up 1.5%, Japanese shares up 4.0%, Chinese shares up 1.9% and Australian shares up 2.8%.
Government bond yields mostly rose, commodity prices rose and the $US fell, which saw the $A push higher.
While the recent rebound in shares has come on good breadth (ie strong participation across stocks) and is confirmed by credit markets and a rally in “risk on” currencies, it’s too early to say that we have seen the lows.
Global growth could still slow further in the short term and there are a bunch of issues coming up that could trip up markets, including US December quarter profit results, trade negotiations, the US government shutdown, the need to raise the US debt ceiling, the Mueller inquiry, Brexit uncertainties, the Australian election, etc.
So markets could easily have a retest of the December low or make new lows in the next few months.
However, our view remains that the falls in share markets – amounting to 18% for global shares, 20% for US shares and 14% for Australian shares from their highs last year to their December lows – and any further falls to come, are unlikely to be the start of a deep (“grizzly”) bear market like we saw in the GFC, and that by year end share markets will be higher.
The main reason is that we don’t expect a US, global or Australian recession anytime soon, as monetary conditions are not tight enough and we haven’t seen the sort of excesses in terms of debt, investment or inflation, that normally precede recessions.
The following points are also worth noting:
First, the US share market has seen six significant falls ranging from 14% to 34% since 1984 that have not been associated with recession and saw strong subsequent rebounds.
Second, each of these have seen some sort of policy response to help end them and on this front, recent indications from the Fed about being patient, flexible and using all tools to keep the expansion on track, are consistent with it pausing its rate hikes this year.
In addition, Chinese officials are continuing to signal more policy stimulus, including cutting banks’ required reserve ratios, and we expect the European Central Bank to provide more cheap bank funding.
Third, negotiations between the US and China on trade look to be proceeding well, however they are at an early stage and won’t go in a straight line.
China announced more tariff cuts and a commitment to treat foreign firms equally and the Vice Premier is set to visit the US in late January to continue the talks.
Fourth, President Trump wants to get re-elected in 2020, so he is motivated to do whatever he can to avoid a protracted bear market and recession.
This includes seeking to resolve the trade dispute and ending the partial government shutdown before it causes too much damage.
Fifth, while the oil price is up from its lows, it’s still down 30% from its high, lowering inflation and boosting spending power.
Finally, a year ago investors were feeling upbeat about 2018 on the back of US tax cuts, stronger synchronised global growth and strong profits and yet 2018 didn’t turn out well.
So, it may be a good sign for 2019 from a contrarian perspective that there is now so much uncertainty and caution around.
Major global economic events and implications
US data was mixed over the past three weeks.
Consumer confidence, the Institute of Supply Management business conditions indexes, small business optimism and job openings all fell.
On the strong side, jobs growth in December was much stronger than expected and wages growth continued to edge higher.
Meanwhile, Consumer Price Index inflation showed a fall in headline inflation on falling energy prices and core inflation stuck at 2.2% year-on-year which is consistent with the core private consumption deflator, stuck at around 1.9% year-on-year.
Mixed US economic data and inflation around target is consistent with the Fed’s more cautious approach and a pause in rate hikes.
Eurozone unemployment fell to 7.9% in November which is well down from its 2013 high of around 12%.
The trouble is that economic confidence slid for the 12th month in a row, suggesting growth momentum is still slowing.
With core inflation stuck at just 1% in December, this will keep the European Central Bank dovish.
Japan saw stronger wages, but still not enough to move the Bank of Japan, particularly with weak confidence readings.
Chinese data has been soft.
Services conditions Purchasing Managers Indices (PMIs) rose slightly in December, but manufacturing PMIs fell and this is of greater significance globally. Reflecting the slowdown in China, Apple cut its outlook, citing slower demand from China.
Falling consumer and producer price inflation in China for December is also consistent with slower growth.
Reflecting this growth slowdown, the Peoples Bank of China cut banks’ required reserve ratio again, freeing up more funds for lending.
Australian economic events and implications
Australian economic data over the last three weeks has been soft, with weak housing credit, sharp falls in home prices in December, another plunge in residential building approvals pointing to falling dwelling investment (see chart), continuing weakness in car sales, a loss of momentum in job ads and vacancies, and falls in business conditions PMIs for December.
Retail sales growth was good in November but is likely to slow as home prices continue to fall.
Anecdotal evidence points to a soft December and reports of slowing avocado sales – less demand for smashed avocado on rye – may be telling us something. Income tax cuts will help support consumer spending, but won’t be enough, so we remain of the view that the Reserve Bank of Australia (RBA) will cut the cash rate to 1% this year.
Another blowout in bank funding costs is adding to the pressure for a RBA rate cut.
The gap between the 3-month bank bill rate and the expected cash rate has blown out again, to around 0.57% compared to a norm of around 0.23%.
As a result, some banks have started raising their variable mortgage rates again.
This is bad news for households seeing falling house prices.
The best way to offset this is for the central bank to cut the cash rate, as it drives around 65% of bank funding.
What to watch?
In the US, expect to see a solid gain in December retail sales, a slight rise in homebuilder conditions but a fall in housing starts and a modest rise in industrial production.
January manufacturing conditions surveys for the New York and Philadelphia regions should show a slight rise and will be watched closely given their plunge last month.
US December quarter earnings will start to flow in, with an 18% year-on-year rise expected, although the focus will be on corporate guidance, with profit growth likely to slow to 5% this year as the corporate tax cut drops out.
In the UK, Prime Minister May’s Brexit deal faces likely defeat in a parliamentary vote on Tuesday.
Even though the UK parliament will force May to come up with a Plan B, there is no majority support in parliament for any alternative! So the Brexit comedy will continue. A “no deal” Brexit could knock the UK into recession and maybe knock 0.5% off Eurozone growth.
Chinese trade data for December (Monday) is likely to show subdued growth in exports and imports.
In Australia, expect declines in both consumer confidence (Wednesday) and housing finance (Thursday).
Outlook for investment markets
With uncertainty likely to remain high around the Fed, US politics, trade and growth, volatility is likely to remain high in 2019.
However ultimately, reasonable global growth and still easy global monetary policy should drive better overall returns than in 2018, as investors realise that recession is not imminent.
Global shares could still make new lows early in 2019 (much as occurred in 2016) and volatility is likely to remain high.
However, valuations are now improved and reasonable growth and profits should see decent gains through 2019, helped by more policy stimulus in China and Europe, and the Fed having a pause.
Emerging markets are likely to outperform if the $US is more constrained as we expect.
Australian shares are likely to do okay, but with returns constrained to around 8%, with moderate earnings growth.
Low yields are likely to see low returns from bonds, but they continue to provide an excellent portfolio diversifier.
Unlisted commercial property and infrastructure are likely to see a slowing in returns over the year ahead, particularly for Australian retail property.
Australian capital city house prices are expected to fall another 5% or so this year, led again by 10% or so price falls in Sydney and Melbourne, on the back of tight credit, rising supply, reduced foreign demand and tax changes under a Labor Government.
The risk is on the downside.
Cash and bank deposits are likely to provide poor returns as the RBA cuts the official cash rate to 1% by end 2019.
Beyond any further near-term bounce, as the Fed moves towards a pause on rate hikes, the $A is likely to fall into the $US0.60s as the gap between the RBA’s cash rate and the US Fed Funds rate will still likely push further into negative territory as the RBA moves to cut rates.
Being short the $A remains a good hedge against things going wrong globally.