Weekly Market Update – 25th May 2018

• The past week has again seen geopolitical issues dominate with renewed trade worries out of the US, the cancellation of the North Korean summit and rising angst around the formation of a populist coalition government in Italy. Despite this US shares managed a slight rise but Eurozone, Japanese, Chinese and Australian shares fell. Bond yields continued to blow out in Italy but declined elsewhere helped by haven demand. Commodity prices were mixed with gold and metals up but oil and iron ore down. The $A managed a small rise with the $US basically flat.

• No trade war, but still a long way from trade peace. Trump has been blowing all over the place on US-China trade talks in the last two weeks no he doesn’t expect much from them, yes the benefits of the initial talks are massive, and no he’s not really pleased with the outcome. But this is just classic Trump who says what he thinks at the time, wants to appeal to his base and will say extreme things in order to get what he wants in negotiations. The good news though is that negotiations between the US and China are off to a good start and China is keen on reducing tensions with the US and the US has put the start of tariffs (which were due from May 22) on hold. But there is still a long way to go a problem that took decades to build won’t be negotiated away in just a few weeks and if there is not enough progress the threat of returning to tariffs remains. But views remain that ultimately a full-blown US-China trade war will be averted. In the meantime of course, the NAFTA renegotiation looks like it has a way to go, Trump has ordered a consideration of imposing tariffs on US auto imports and the EU’s exemption from US steel and aluminium tariffs will expire again on June 1 (but is likely to be extended). Given that 29% of US auto imports come from Mexico and 19% from Canada the latest move is clearly designed to pressure them on NAFTA. But it will also impact Japan, Korea and Germany. But it’s all about Trump posturing around negotiations and like the steel and aluminium tariffs any impact is likely to be significantly watered down from what markets initially fear.

• June 12 summit between Trump and Kim Jong-Un killed for now by the Libyan model. With North Korea having a flouted agreement and gone hot and cold for decades it was always debatable as to whether much would come of the summit. So now we are back to where we were. But this doesn’t mean military conflict is on the way. The North Korean regime knows that it will get annihilated if it does anything and the US knows that a pre-emptive strike will result in mass casualties in South Korea. And of course, there is still a chance a summit could happen (as North Korea is economically desperate) albeit only ahead of the US mid-terms if Trump sees a very good chance of success.

• Turn down the noise on Trump. There is no denying that Trump’s comments impact markets and the risks around Trump are greater this year than last (with tax reform and deregulation behind us, the mid-terms approaching and the Mueller inquiry getting closer to Trump). However, much of what he says is bluster and posturing. Yes, he should be taken seriously, but not literally. And more fundamentally with the investment fundamentals remaining fine the key for investors is to turn down the noise on Trump.

• Back to the Eurozone crisis? Investors are right to worry about a populist Government in Italy, it’s proposed fiscal policies will blow the Italian budget deficit through the EU limit of 3% of GDP leading to conflict with the EU, sanctions, the ECB excluding it from its bond buying program and ratings agency downgrades. However, anticipation of this and the risk that 5SM and the Northern League return to their policy of wanting Italy to exit the Euro is already pushing Italian bond yields sharply higher as bond holders try to protect against redenomination risk or default. So far this month Italian 10-year bond yields have been pushed up by 69 basis points to 2.38%. This is a long way from the 2011 crisis highs of around 7%, but the more yields rise from here the more it will hit Italian banks, borrowing costs and hence the Italian economy. Ultimately the Italian Government will have to back down as a result and it will all look a bit like what happened with Syriza in Greece, with Italy remaining in the Euro (because it’s too costly to leave). But in the process, it will be bad news for Italian bonds and shares, will act as a drag on the Euro and will cause occasional bouts of volatility in share markets (including Australian shares – recall the volatility around Grexit). The risk of a move by Italy to exit the Euro triggering contagion to the rest of the Eurozone though is low as countries like Spain, Portugal and Ireland are stronger than in the crisis years and support for the Euro is high.

• Time to remain alert but not alarmed regarding Chinese debt. This issue has been wheeled out regularly for years and the RBA had another go at it in the last week. Yes its gone up too fast, yes the growth of “shadow banking” has been an issue, yes some of the debt will turn bad and so yes it’s a risk. But there is nothing new here. China is different to most countries that get into debt problems in that it borrows from itself (so there’s no pesky foreigners to cause an FX crisis), much of the rise in debt owes to corporate debt that’s partly connected to fiscal policy (and so the odds of government bailout are high) and the key driver of the rise in debt is that China saves around 46% of GDP and much of this is recycled through the banks where it’s called debt. So unlike other countries with debt problems China needs to save less and turn more of its savings into equity than debt. The Chinese authorities have long been aware of the issue and have been working to slow debt growth. So yes, keep an eye on it but there is no need for alarm.

Major global economic events and implications

• US data remains solid. While home sales slipped in April, home prices continue to rise and the Markit business conditions PMIs rose further in May consistent with strength in regional business surveys. Meanwhile the minutes from the Fed’s last meeting didn’t tell us much that we didn’t know: the meeting leant to the dovish side with Fed upbeat on the economy and on track for another hike next month, but tolerant of a temporary inflation overshoot of 2% as its consistent with the symmetric inflation target so just because inflation goes above 2% doesn’t mean it will slam on the brakes. However, its comments are consistent with three more rate hikes this year (starting in June) whereas the money market is still not there yet.

• Japan’s manufacturing PMI fell in May but remains consistent with moderate growth. A further fall in Tokyo’s core inflation to just 0.2% yoy highlights yet again that the BoJ is along way from being able to exit easy money. Which in turn is negative for the Yen (barring bouts of safe haven demand).

Australian economic events and implications

• Australian economic data was on the soft side over the last week with skilled job vacancies falling and construction activity coming in virtually flat in the March quarter. Public construction is rising strongly as the infrastructure boom rolls on, but this is being offset by weakness in private sector construction driven by non-residential building. The latter suggests a soft input into March quarter GDP numbers to be released in early June.

What to watch over the next week?

• In the US, the focus will be back on trade and the Fed. Monday is the deadline for finalising the list of Chinese products to be subject to tariffs and it’s also the deadline for the US Treasury to propose restrictions on Chinese investment in the US. Meanwhile the minutes from the last Fed meeting (Wednesday) and a speech by Fed Chair Powell (Friday) are likely to confirm an upbeat view on the US economy and inflation and that it remains on track for more interest rate hikes with the next move in June. They are also likely to push the financial market closer to factoring in another three hikes this year (from expecting just two). On the data front expect May business conditions PMIs (Wednesday) to remain solid at around 55, home sales (due Wednesday and Thursday) to fall back after solid gains in March, home prices (Thursday) to show further gains and durable goods orders (Friday) to rise.

• Eurozone business conditions PMIs (Wednesday) for May will be watched for a stabilisation around a still solid 55 after seeing falls from highs earlier this year.

• In Australia expect a 0.5% rise in March quarter construction activity (Wednesday) after a very weak December quarter. Skilled vacancy data will also be released and a speech by RBA Governor Lowe (Wednesday) is likely to affirm that the RBA remains comfortably on hold.

Source: Domain, AMP Capital.

Outlook for markets

• Volatility in share markets is likely to remain high as US inflation and interest rates move up and as issues around President Trump (trade, Mueller inquiry, etc) continue to impact, 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. Continue to expect the ASX 200 to reach 6300 by 2018 end.

• Low yields and capital losses from rising bond yields are likely to drive low returns from bonds. Australian bonds are likely to outperform global bonds helped by the relatively dovish RBA.

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

• National capital city residential property prices are expected to slow further as the air continues to come out of the Sydney and Melbourne property boom and prices fall by another 5% this year, 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 likely has more downside to around $US0.70 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.

Source: AMP CAPITAL ‘Weekly Market Update’

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