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Within this month’s update, we share with you a snapshot of economic occurrences both nationally and from around the globe.

Global share market recovers from August dip

– Australian property market appears to be stabilising
– US Fed cuts rate in split decision
– The RBA cuts again by 0.25%
– Europe returns to monetary stimulus

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact our team.

The Big Picture

Amid largely anecdotal reports of an improving Australian property market, the private data service, Corelogic, produced hard evidence that September witnessed quite strong price growth in both Sydney and Melbourne.

While the June and July interest rate cuts from the Reserve Bank of Australia (RBA) may have been a contributory factor to house price increases, the regulator also slackened certain lending criteria. Moreover, Australian property prices typically have a strong surge every five or ten years followed by an extended period of flat or slightly falling prices. Perhaps recent price action is the initiation of the recovery after two years of declining prices.

Corelogic’s data release occurred the day before the October 1st RBA board meeting. The collective wisdom of analysts and economists was that the RBA would cut its rate to 0.75% which it did. Of course, the RBA also has its eye on our labour market, overseas interest rates and our economic growth.

Australia’s second quarter growth came in at the start of September at a weak 0.5% for the quarter or 1.4% for the year. On the other hand, the jobs market remains reasonably strong.

However, with the US and the EU cutting rates in September, the RBA is somewhat forced to keep in step to try to stop our currency appreciating.
The US Federal Reserve (the Fed) cut rates in mid-September but in a split decision. Three members voted against the cut and only seven of 17 members expect a further cut this year.

The mood around US rates materially changed over September. Gone are those predicting a near term recession based on the difference between short and long US rates.  It seems that just one more strong retail sales data release of +0.4% for the month was enough to swing opinions. We were never in that near term recession camp.

Although there should always be a nonzero probability expectation of a recession, we see no current data sufficient to raise that probability to a significant percentage.

The US jobs data were again strong with wages growth at last solid at 3.2% and the unemployment rate remaining at a near 50-year low. The consumer is underpinning the US economy.

The European Central Bank (ECB) not only cut its rate by 10 bps (0.1% point) to  0.5% but it also reintroduced quantitative easing (QE) to the tune of $20bn per month for as long as is necessary. With the new ECB president, Christine Lagarde, taking over the reins in November, she is now locked in to a strong monetary stimulus policy.

The latest EU economic growth was only +0.2% for the June quarter. The ECB forecast for the year ahead is only +1.0%.

China has just started its Golden Week celebrations as it marks the 70th anniversary of the People’s Republic of China with its biggest parade to date.
Much of the standard China data monthly releases just missed expectations during September but that month ended with the Purchasing Manager’s Index (PMI) for manufacturing beating expectations at 49.8 – which is only just short of the ‘50’ that divides contraction from expansion. The services PMI at 53.7 is well in expansionary territory.

While stock markets generally turned the corner after a volatile August, the US Democrats have started an impeachment investigation against President Trump. Since an impeachment would need a two-thirds majority in the Republican-held Senate, it is a most unlikely event. And the markets are seemingly immune from the continuing anti-Trump campaign.

Asset Classes
Australian Equities

The ASX 200 index grew by around 2% over September and volatility was quite low. Financials stocks that include the big four banks had a particularly strong month.

We have calculated that company earnings revisions have resulted in a slight softening in our predicted capital gains over the next 12 months to about the historical average rate of 5%.

Foreign Equities

The S&P 500 also gained about 2% over September. Both the ASX 200 and the S&P 500 have gained nearly 20% over the course of 2019-to-date. The S&P 500 closed the month near all-time highs.

In spite of the Brexit woes. The London FTSE and the German DAX Indices posted particularly strong gains over September.

Bonds and Interest Rates

The key “2-10 spread”, being the US 10-year bond yield minus the 2-year equivalent turned a fraction negative (a so-called yield-curve inversion i.e. the shorter maturity interest rate is higher than the longer dated maturity interest rate) towards the end of August. That spread is now again positive which is the normal state of affairs.

The Fed cut rates by 0.25% in September. The CME Fedwatch tool that prices the future course of the Fed rate has a 55% chance of rates being on hold at the next meeting on October 30th. Currently it is indicating there is a 33% chance of no more cuts this year.

With the Fed and the ECB cutting rates in September, the outlook for bond yields continues to be soft making equities relatively attractive.

Other Assets

Oil prices spiked in mid-September as a drone destroyed part of a Saudi oil installation. However, a swift reaction managed to bring stability to prices after a few days. Elsewhere, Iron ore prices strengthened.

Regional Review
Australia

The Australian unemployment rate increased one notch (0.10%) to 5.3% in the September labour survey release. Nearly 35,000 jobs were created but full-time positions fell by about 15,000 however, part-time jobs swelled by over 50,000.

The economic growth estimate was released at the start of September. GDP grew by only 0.5% for the quarter or 1.4% for the year. Retail sales were particularly weak coming in at  0.1% when an increase of +0.2% was expected.

China

China is celebrating 70 years since the founding of the People’s Republic of China (PRC). Meanwhile, the demonstrations in Hong Kong continue – but only at weekends! There appears to be no end in sight.

China trade has been affected – presumably by the tariff war. Exports fell 1.0% in the latest month while imports fell by 5.6%.

The official manufacturing PMI rose again in September but, at 49.8, it is still below the 50 cut-off that denotes expansion. The services PMI continues to be very strong at 53.7.

Trump delayed certain tariff increases by a couple of weeks so as not to detract from the PRC celebrations. There does appear to be a slight softening in the trade war and China officials are again expected in the US capital again in October.

US

The US unemployment rate stayed at 3.7% and wages growth was 3.2%. Retail sales had another strong month with a growth of 0.4%. The second revision to June quarter growth left growth unchanged at a modest 2.0%.

Nike, the sporting clothes manufacturer, posted very strong sales results. It appears that the US consumer is strong enough not to need price discounting so that gross margins have strengthened.

Europe

Boris Johnson, the UK prime minister, has been found to have illegally called the proroguing of parliament in the lead up to the Brexit deadline on October 31st. There appears to be a deadlock since the opposition won’t agree to a general election without strong conditions that are unacceptable to Johnson.

European growth remains very weak at +0.2% for the latest quarter. Official predictions are only for a 1% growth over the year but the ECB has started a new round of monetary stimulus.

Rest of the World

Japan’s industrial production slumped  1.2% in the month as an increase in sales tax from 8% to 10% is being ushered in. Japan’s core inflation came in on expectations at 0.5%.

The OECD lowered its global growth forecast to 2.9% for the year.

Within this month’s update, we share with you a snapshot of economic occurrences both nationally and from around the globe.

US Federal Reserve cuts rate

– US economic data strong
– Australia cuts rates too
– China data surprises on upside

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact us.

The Big Picture

Anyone focused on US economic data – but avoiding media coverage – could be forgiven for being shocked about the current US Federal Reserve (the Fed) move on interest rates.

The Fed had not cut rates since 2008 until July 31st and last raised rates in only December 2018. The latest GDP growth came in at 2.1% when the Fed had expected 1.8% and the markets 2.0%. The consumer component of GDP was particularly strong at +4.3% but business investment (with the uncertainty of trade war solutions) fell  5.5%.

The latest US jobs number saw 224,000 new jobs created against an expected 160,000 while unemployment (at 3.7%) was all but at historic lows. Wages growth was 3.1% and core inflation was 2.1% (the target is 2.0%).

Retail sales came in at +0.4% for the month. That made three good readings in a row after the first was initially printed as negative before being revised upwards in subsequent months. The US consumer is strong and consumers contribute about 70% to economic growth hence the importance of domestic consumption to US growth.

So why was the market pricing in a certain cut for the end of July with a material chance of a double rate cut? The day before, a CNBC survey pronounced that only 48% thought the Fed should have cut at the end of July while 95% said they thought the Fed would cut!

There was absolutely no case for a cut on past data alone. The market, and President Trump, were bullying the Fed into an easing programme for two reasons. The first was as an insurance policy against future problems flowing from the US-China trade war. The second was because of the easing bias that is sweeping central banks across the world. In a race to the bottom, the US needs to keep its policy aligned with rest of the world.

That the Fed just cut rates by one quarter of a point while flagging further future cuts has introduced a new risk. What if the US economy continues to be strong and maybe even grow stronger on the back of the rate cuts?

On the face of it, a strong US economy is great – except that the Fed would then be forced to hike rates again. Such flip-flopping would likely cause further uncertainty in the economy and introduce the chance of the Fed then tightening too quickly and too far. Over-reaction to trying to slow down a strong economy is usually the basis for causing a recession! But, in the meantime, there would likely be strong gains to be made on markets if that scenario pans out.

Either way – with a necessary monetary easing or one unnecessarily forced on the Fed – markets should continue their positive aspect with new all-time highs being reached.

At home in July, the Reserve Bank of Australia (RBA) cut rates for the second month in a row. That was after about two and a half years on hold. The new official rate of 1% is not good news for conservative investors in cash and/or term deposits as the whole interest rate structure is expected to follow suite.

Our unemployment rate was again 5.2% and, while not showing sign of material improvement, is not the stuff of recessions. On top of that the government got its $158bn tax package through parliament. Around 10,000,000 tax payers may soon get an extra $1,000 or so in rebates. Perhaps that is why the only bright light in Westpac’s consumer sentiment index was the surveyed imminent purchase of a domestic consumer durable such as a new washing machine or fridge.

Those hoping for gloomy news at first took comfort in China’s latest slightly lower economic growth statistic of 6.2%. It was bang on expectations but retail sales easily beat expectations (9.8% against 8.3%) and industrial output (5.8% against 5.5% expected) spoilt their party. China is not (yet?) showing signs of having economic problems.

With US and China economic data strong, and future Australian data supported by tax and interest rate cuts, all looks reasonably stable for investors in the months to come – and maybe for even a lot longer!

Asset Classes

Australian Equities

At last the ASX 200 closed above the previous high posted in late 2007! Of course, when dividends are included that old high was breached a long time ago.

We have the ASX 200 as being a bit overpriced, making headwinds for further price gains the short-term. However, we find the underlying earnings story sufficiently strong to propel the market even higher over the rest of 2019. However, the August reporting season for companies listed on the ASX will colour that story for the rest of 2019.

Foreign Equities

The S&P 500 breached new all-time highs in July and there doesn’t seem to be any end in sight for the rally – at the moment. At the end of July about half of US listed companies had reported their second quarter earnings. Around 75% of those companies had so far beaten expectations – the usual number because expectations are often reset when the going gets tougher. However, the underlying earnings story is still quite positive. And it’s not just the big tech companies that look promising. Consumer discretionary companies like Starbucks and MGM posted great results and their share prices jumped over 5% on the news.

Bonds and Interest Rates

The big ‘lever’ all central banks have at their disposal to attempt to meet their targets – such as price stability and full employment – is coming under question.
There is a fairly clear linkage between interest rates and unemployment. Higher rates are a disincentive to investment which in turn causes an upturn in unemployment. Lower rates stimulate investment intentions given everything else is unchanged. The direct link between rates and inflation is less clear. It is usually argued that, as unemployment rates fall, there is pressure on wages because resources become scarce. Increases in wage inflation might then reasonably be expected to flow through to increases in price inflation.

The problem is that around the world (but particularly in the US) the link between unemployment and inflation appears to be broken. Unless there is a strong and stable negative (or inverse) relationship between unemployment and inflation, central banks cannot successfully target both unemployment and inflation with only one instrument – interest rates.

The (inverse or negative) relationship between unemployment and wage inflation was first reported by Bill Phillips, a New Zealand professor at the London School of Economics, in a 1958 academic publication. At various times, the stability of this relationship has been called into question. In the 1970s the so-called Phillips curve was widely thought to be no longer relevant.

By modifying the hypothesis in various ways, scant support has been found for a modified Phillips curve in more recent times. But a relationship which only lasts for a short time before changing is of no use to policy makers. In his July 12th testimony before Congress, the Fed chair pronounced the Phillips curve is ‘dead’.

There is nothing unusual about (academic) economic hypotheses coming in and out of favour. Economics is not an exact science. However, in the case of a Phillips curve, failure of the curve means that central banks cannot reasonably meet their dual objectives.

It is not a question of changing the target band for inflation to a new lower level. A new instrument needs to be added to the central banks armoury or the inflation target needs to be dropped altogether!

Nevertheless, central banks are on a new co-ordinated round of policy easing and this does not bode well for conservative investors. Cash rates, and longer bond yields, are likely to be lower for longer. As a result, some investors are moving to, or staying with, the so-called ‘bond proxies’: stocks that produce strong reliable dividends with not necessarily any great prospect of capital growth. Many infrastructure and utilities stocks are prime examples of bond proxies.

The Fed cut as expected in July and also ended its debt drawdown two months early. At first the market reaction was neutral but then Wall Street fell by over 1% when, under questioning, Fed Chairman Powell, said that it was not necessarily the start of a trend.

The RBA also cut official cash rates but the ECB was ‘on hold’. However, the ECB president stated that it had an easing bias for future policy.

Other Assets

Oil prices have been far less volatile than one might expect given the sanction issues over Iran’s nuclear activities.

The price of iron ore rose slightly over July and it is up 66% on the year-to-date.

The price of gold was up fractionally over July but has risen 12% in $US terms since late May.

Regional Review

Australia

The Westpac consumer confidence sentiment index fell 4.1 points to 96.5 in July meaning that there are now more pessimists than optimists in Australia. Could it be that consumers, buoyed by the federal election results and the positivity on taxes that went with it, got spooked by the RBA’s rate cuts implying that our economic prospects have weakened to the point of requiring such stimulus?

With little bad economic data this year in Australia, it is difficult for many to understand how the RBA can go from ‘the next move in rates is up’ to making two consecutive cuts with more being flagged in official speeches.

There does seem to be a nascent recovery in house prices – or at least an end to the falls. APRA, the financial services regulator, has scrapped a recent rule about how much people can borrow that has eased credit. That appears to be the main reason for the house price movements. It is far too soon for the rate cuts to have had any effects – especially as not all of the RBA cuts flow through to home loan rates.

The unemployment rate stayed at 5.2% which is not great but far from causing sleepless nights for market commentators. The headline jobs number was flat but it is notoriously volatile. The more stable official trend employment data came in at 21,100 new jobs created in June which is quite acceptable.

Unsurprisingly, the Australian inflation rate came in below the RBA target range of 2% to 3% for the 14th consecutive quarter. The headline rate was 1.6% for the year or 1.4% using the RBA’s preferred core measure of inflation.

China

It should always be stressed – when considering China’s economic growth – that any economy transitioning from a low growth rural economy via a fast growth development programme to a high-powered mature economy will go through various phases. At this point of the cycle we should expect China growth to fall from the double digits of 2008 to around the trend growth rates in countries like the US at around 2% to 3% but, in an orderly fashion.

The latest Chinese economic growth report came in at 6.2% which matched expectations. If a developed country like the US or Australia came in at that level, monetary and fiscal policy would be used to slow down growth to trend rates pretty quickly. On the other hand, we might expect China’s growth rates to glide gently down to around 3%. In the last decade, China growth has dropped from around 10% to 6%. If it falls to 3% in another decade, that might be quite reasonable but the timetable should also depend on monitoring the social situation in China during this transition.

Unfortunately, some commentators do not appear to appreciate the process of the transitioning of economies such as China. They said that 6.2% being less than a recent, say, 6.5% is a worry. Not so! One only has to look at the retail sales and industrial output data released on the same day as GDP growth! Retail sales beat the expected 8.3% with 9.8% and industrial output beat forecasts of 5.3% with a report of 5.8%.

The China manufacturing PMI was a little light on at 49.7. It was the third month on the run below the 50 mark that separates expansion from contraction but it was up on the previous month and it beat expectations.

Some might have expected worse data for China with the trade war still being unresolved. However, China can and is putting its own policies in place to combat any negative trade impacts. For example, it is building much needed infrastructure and it is adjusting certain lower-tier monetary ‘levers’ such as the RRR (required reserve ratio). The RRR is the amount of capital a bank must hold on deposit against its outstanding liabilities, i.e. the lower the RRR the more money the bank is able to lend out.

US

The last US jobs report bounced back after a one-off low number for May. The latest 224,000 new jobs number is well above recent annual averages of around 180,000.

Not only have the main macro statistics been painting a strong picture for the US economy, even the more micro-based numbers are often beating expectations. The Philadelphia Fed puts out regular readings of an index which measures local manufacturing output. The market was expecting a ‘5’ but it came in at a whopping 21.1.

The debt ceiling – which can and does cause government shutdowns when it is too low – has just been lifted so that no such problems can occur for the next two years at least (a point in time after the next US presidential election).

Europe

The ECB’s president Mario Draghi is just ending his term in office and is to be replaced by Christine Lagarde – the former managing director of the IMF. Since she has no experience in central banking or qualifications in economics (she trained as a lawyer) it is difficult to predict how she will perform.

Jerome Powell, chairman of the US Fed, is also a lawyer and he made a flew blunders since his appointment by US President Trump. We recall that he put markets in a spin at the start of October 2018 with a comment that the ‘neutral’ interest rate was well above current rates. Three months later, and after a rate hike, he presented a very dovish tone and he is now on an easing bias! Perhaps Lagarde can learn from Powell’s mistakes rather than creating her own.

The ECB was ‘on hold’ in July but it has flagged there is monetary policy easing to come. Hopefully, the hierarchy of the ECB will maintain the momentum. The European Union economy is not doing well.

At last, Boris Johnson has been confirmed as head of the ruling Conservative (Tory) party and, hence, PM of the UK. His Brexit stance has been to remove the ‘Irish backstop’ or the divide between the Republic of Ireland and the UK’s Northern Ireland from future negotiations.

Johnson claims the UK will ‘Brexit’ (exit from the European Union) on October 31st come what may. That is, Britain will leave the EU with or without a new deal in place. Some sort of volatility must ensue but we see no great impact on the Australian economy or our stock market at this point in time.

Rest of the World

Iran problems continue to be unresolved. Oil tankers and navies are interacting in that region while sanctions are being imposed over Iran’s nuclear programme. Naturally there is a fall out for oil prices but, so far, oil prices have been reasonably well behaved. Perhaps the large-scale production of shale oil in the US has helped stabilise oil prices.

Also, the civil unrest in Hong Kong continues well beyond what was initially expected and the world watches on to see how Beijing authorities resolve this situation. While it persists, it is a source of uncertainty.

Within this month’s update, we share with you a snapshot of economic occurrences both nationally and from around the globe. Central banks go soft on monetary policy:

1. Australia cuts its benchmark rate
2. US Fed holds off on a cut but flags a couple are on the way
3. The US consumer still displaying confidence!

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact your Financial Adviser.

The Big Picture

After nearly three years of keeping interest rates on hold, the Reserve Bank of Australia (RBA) cut its benchmark Cash rate from 1.5% to 1.25% on June 4th, and again on July 2nd. These cuts were widely anticipated as the easing cycle had been flagged in various speeches by senior RBA personnel. The big question is, of course, what next? For long term investors, there is no need to be overly concerned by every cash rate adjustment by the RBA.

We just need to know that monetary policy is managed responsibly – and that the government is acting on the promised tax breaks. Our unemployment rate again came in at 5.2% p.a. and the first NAB business surveys of business confidence taken after the election were mildly positive. The US Federal Reserve (Fed) did not cut rates, as was widely expected, but it did remove the word ‘patient’ with respect to its policy stance from its press release. US Official rates look set to be on the move back down after last being increased in December 2018. In the previous meeting of the US Federal Open Markets Committee (FOMC) held in March 2019, 11 committee members predicted rates to be on hold for 2019 with four members predicting one hike and another four predicting two hikes in the remainder of 2019. This time around one member even voted for a cut on the day and eight predicted cuts during 2019. The market is predicting a good chance of more than two cuts this year.

We feel that outcome is unlikely because there are no clear signs of problems. The proposed cuts are seen as being more pre-emptive than reactive. The European Central Bank (ECB) and the Bank of England have also kept official rates on hold but the Reserve Bank of India (RBI) made its third cut in rates in 2019. However, the RBI interest rate stands at 5.75%! Central banks around the world are moving to an accommodative stance which is one half of the equation. The G-20 meeting held at the end of June in Osaka canvassed the need for some coordinated fiscal response – the other half required – to complete the economic management picture. The G-20 was set up just after the onset of the GFC to coordinate global economic management. In recent times, the G-20 has been behaving more like a G-2 with 18 spectators. The main focus of all is on the US-China trade negotiations. US President Trump and Chinese Premier Xi, in a lunch immediately after the G-20, agreed to resume negotiations and no new tariffs are planned. Trump was quoted as saying, “We are back on track”. The US economic data released in June were a bit mixed. On the positive side, retail sales grew by +0.5% for May and the April figure – initially reported as 0.2% – was revised upwards to +0.3%. The US new jobs data for May came in well below the expectations of 180,000 at 75,000. Those numbers do get revised and also jump around so that alone does not worry us necessarily. On top of that, the unemployment rate remained at a very low 3.6% and the wage growth rate was a creditable 3.1%. Since Trump has begun his re-election campaign there are bound to be flurries of negativity from his opponents. We focus on the facts – and facts in context.

There are no reasonable grounds to state that US economic data are pointing to a major slowdown. Of course, times can change so we will continue to monitor any material economic data output. Data points from China were also a bit mixed. Retail sales data impressed to the upside but its industrial output figure missed expectations. A very good financial year for share markets has just ended and the next is set to start smoothly.

Asset Classes Australian Equities

The ASX 200 posted its sixth successive monthly gain for 2019 in June. The capital gain was +3.5% for June and +6.8% for the financial year (FY19). Materials was the standout sector in June with a gain of +6.3%. The Consumer Discretionary sector was the only one that went backwards in June.

We have the broader index moderately over-priced and that brings down our forecast for gains in FY20 to about the historical average. Fundamental earnings remain resilient and supportive of prices generally. Given that the RBA has indicated its easing cycle – and the government is on the case with proposed tax breaks to enact, any poor economic data in the coming months is less likely to have a big negative impact on our market. Indeed, the shifts in monetary policy of central banks around the world is likely to continue to be supportive of stock markets.

Foreign Equities

The Dow Jones index experienced its best June gain since 1938. However, that did follow a poor result in May that we did not share in Australia. Although different countries have different end points for their financial years, we can impute that the ASX 200 and the S&P 500 behaved similarly over our FY19 and well ahead of the UK, Germany and Japan. Emerging Markets went backwards over FY19.

Bonds and Interest Rates

The change in emphasis in monetary policy around the world is putting further downward pressure on bond yields. The cuts in the official cash rate by the RBA is not good news for those investing in term deposits. The 90-day bill rate is only 1.21% and the 10-year bond yield is now at 1.35%. Both are below current levels of inflation meaning that the so-called real (inflation adjusted) interest rates are negative in Australia. On the other hand, the expected yield on the ASX 200 over the next 12 months is 4.4% excluding franking credits. The search for yield will likely underpin our share market. The Fed could possibly cut its reference (official) interest rate at the end of July with another cut to come later in the year. Some market participants are factoring in three and four cuts in rapid succession. We think the US Fed will act more conservatively i.e. not cut interest rates so quickly to avoid the need to reverse its easing monetary policy stance if the US economy happens to prove more resilient than expected during the remainder of 2019. While some continue to talk of recession in the US, the fact that 2020 is an election year there is the prospect that President Trump could deploy additional spending. This could be a further reason the US Fed may be less inclined to embark on an aggressive rate cutting program without clear evidence of fundamental weakness in the US economy.

Other Assets

June was a very strong month for iron ore as prices responded to supply shortages. Gold and Oil prices rallied during the month spurred on by rising political tension in the Middle East as the US and Iran engage in tit for tat engagement in relation to Iran talk of re-starting its nuclear program and attacks on oil tankers in the Persian Gulf.

Regional Review Australia

There was some fear that our economy will continue to slow based on the last reported GDP growth being the lowest since the onset of the GFC. However, the Australian jobs report for May was positive. The unemployment rate stayed at 5.2% and the creation of 42,300 new jobs were reported.

Also, on the bright side, the two NAB business confidence surveys – collected after the election – were mildly encouraging. Given that the government is going to try hard to launch some fiscal stimulus, in terms of tax cuts and rebates, our economic future seems to have been somewhat stabilised in the near term. The next quarter’s economic growth figure ended on June 30th so when June quarter growth is reported (on September 4th), it will be from the ‘old regime’. We remain hopeful that there will be some promising signs reported towards the end of this year in response to monetary and fiscal stimuli. Although a second rate cut from the RBA is most likely, we expect a pause before the next one is implemented to avert the appearance of the RBA panicking. China China’s retail sales came in at 8.6% (against an expected 7.1%) for the year but that number should be read in conjunction with the softer 5.0% industrial output reading that missed expectations by 0.5% points. After half a year of the new tariffs imposed by the US, the Chinese economy is holding up much better than many expected. Infrastructure spending over the coming period (on the belt and road initiative) is expected to help support economic growth in China.

US

The last US jobs report was mixed but that was not of a material concern for the moment. The key figures of the unemployment rate and wages growth were more positive. However, we will soon have the next jobs number and that might well overshadow the unexpectedly low number reported at the beginning of June. It was the retail sales data that really impressed – because so much gloom surrounded the reading released in May. That 0.2% April growth was revised upwards to +0.3% and the new May growth was reported at a solid +0.5% for the month – or +3.2% for the year.

Europe

The ECB announced it was extending its low interest rate policy for longer and also it is revisiting its bond buying programme. After ending the so-called Quantitative Easing (QE) policy in December 2018 it is considering reinstituting that policy, clearly a sign that growth in the region remains anaemic. The German auto industry is suffering from Trump’s tariffs and it is not anticipated that growth will be returning in the near to medium term. In summary it appears the EU is in economic limbo. When the new UK prime minister is selected, it seems that he will move to exit Europe by October 31st even if no deal is done. That may cause some volatility in markets but in reality it should have limited impact on Australia and its major trading partners.

Too much talk of recessions!

• Does anyone have a strong track record in predicting recessions?
• US and China ready to act
• Australia likely to cut rate and give a fiscal boost

The Big Picture

Most of the market volatility in recent times has been due to fears of an impending recession – in the US, in Australia, in Europe. Let’s put this nervousness in context.

Paul Samuelson, the 1970 winner of the Nobel Prize in Economics, once quipped that the stock market predicted 11 of the last five recessions!

Two and a half years ago – when Trump was about to start his first term as President – Bloomberg reported that “a pack of Nobel Laureates” gave Trump’s economic policy the “thumbs down” and one even predicted a severe recession as a result. The US has had two and a half years of very strong growth and the unemployment rate has dipped to 50 years lows.

But, perhaps, the best comment on recessions was made by an anchor on CNBC last week. He likened recession calling to badger watching in England. To paraphrase, “Badgers are rarely seen in the English countryside (they are nocturnal and live in very long inter-twined underground burrows). But we know they exist because, from time to time, we see one on the side of the road after having collided with a car.” 

In short, recessions are almost impossible to predict by any economist but we know they exist and one will occasionally happen with almost no warning!
Some headline-seeking commentators are suggesting the fact that a short-term interest rate (say 90-day rate) is greater than a long rate (say the 10 year) is symptomatic of an impending recession. 

In the past, central banks have sometimes forced the short-term rate higher (above the long rate) to slow down a booming economy and have gone too hard. This time the short rate has not been pumped up but the long rate has fallen on inflation expectations. There is no reasonable evidence that this phenomenon precedes recessions! Of course, we acknowledge the past possible impact of over-zealous central banks.

If Trump forces tariffs too high with China, he could cause a recession. But Trump cannot afford the US economy to stop booming before the November 2020 presidential elections. From past experience we know that China will not stand by and let its economy stumble. Both will do something – and it does not matter what – to prevent a recession or even a significant economic slow-down.

Before our Federal election, our Reserve Bank (RBA) looked reticent to cut rates and we were facing the prospect of higher capital gains tax; restrictions on negative gearing; and restrictions on franking credits. Whatever one’s shade of politics, we now face none of these four factors. The RBA has stated (with almost certainty) that it will cut rates on June 4th (and probably again a few months later) and the three tax policies are not shared by those in government.

Markets had priced in those four factors and must now unwind those expectations. Our labour market and economic growth were fine (but not great) and, on top of that, there are now to be tax rebates of more than a thousand dollars in July/August for a whole swathe of tax payers. Even if our economy wobbles for a couple of months, it looks set to bounce back in the second half of the year.

Analysing monthly data on our stock market since 1893, we note there has only been one instance (in around 1,500 months) when the market fell more than 15% in one month (the ’87 crash) and the prior month in that case fell nearly 15% as a warning. Importantly, the market then had more than doubled in just more than one year before the crash! In less than 1% of cases did the market fall more than 10% in one month.

Our thesis is simple. If we sell too early, we could miss out on big gains. And if we had sold before the peak, what would then induce us to buy back in while the market continued to climb? We would have been waiting at least 30 years after the last recession in Australia (while the US had three) from 1990 to the next! We believe it is better not to try and predict the top but to wait for it to become self-evident. The potentially small loss from a (then) previous high is likely to be small compared to the gains from the previous big lows or premature sale date!

Recessions and deceased badgers alike will, unfortunately, come and go. Investing needs strong, thorough analysis, a proven philosophy and prudent application. 

Asset Classes
Australian Equities

While most major markets around the world finished May firmly in the red, the ASX 200 kept its head above water. The 5.9% surge in Financials stocks on the day after the election results of obviously helped but Materials, Health and Telcos also put in better returns than Financials over the month.
Since we have the ASX 200 only modestly overpriced with strong earnings growth prospects, we see these factors as being supportive of the share market over the second half of the year.

Foreign Equities

The May sell-off on foreign stock exchanges comes after four very strong months of gains in most cases. We now have Wall Street rated as fairly valued with positive prospects for earnings growth with the potential for further gains should concerns over the tariff war subsides.

Bonds and Interest Rates

The CME Fedwatch tool for pricing possible rate changes by the US Fed this year continues to be volatile in its predictions. The latest data identifies one cut this year as the most likely scenario followed by two cuts and then no cuts. Even three cuts have a 10% chance!

The Fed pretends to be standing firm but the market does not agree.

With the drop in 10-year bond yields, the short-term interest rates are above those at the longer end. While this behaviour has concerned some recession watchers, we do not agree with their analysis. 

With the Fed Funds interest rate range at 2.25% to 2.5%, we cannot agree that there is currently tight monetary policy – the phenomenon which arguably caused some previous recessions when short term rates were higher than longer term rates (an inverted yield curve).

The RBA has stated that it is all but certain to cut its benchmark cash rate on June 4th. Another is then likely in the second half of the year. That means our benchmark cash rate may well end the year at only 1% (and possibly below that next year).With bond rates so low, growth assets such as equities, property and infrastructure are offering comparatively attractive yields. 

Other Assets

Iron ore prices shot through the roof after the Brazilian mine crisis. Oil prices have been a little volatile due to the Iran sanctions but the prices of both major commodities remain firm. 

Regional Analysis
Australia

The federal election gave a surprise, slender majority to the incumbent coalition parties. Many speculate on the reasons for the upset but, for investors, the result means no increased capital gains tax, loss of franking credit refunds or removal of negative gearing. In addition, they will also implement tax rebates of approximately $1000 to a large group of middle-income earners.

While the government will not also have a majority in the senate, it will likely have fewer cross benchers to woo to get its policies through. We look forward with anticipation to a stable government for coming three years.

On the employment front the labour force data were not strong. The unemployment rate rose to 5.2%, up from 5.1% the month before and from 4.9% the month before that. With imminent rate cuts from the RBA and a lowering of borrowing requirements for home loans from the regulator, any dip in economic fortunes should be quite short lived.

Wages grew by 2.3% over the year and the minimum wage rate was just increased by 3% to $740 per week. Price inflation is below 2%.
Just prior to the election we lost one of our truly great leaders in Bob Hawke, aged 89. Along with Paul Keating, he internationalised our economy to make it the great one we all enjoy today. Vale Mr Hawke.

China 

Unusually all of the main Chinese data released in May missed expectations. However, based on past experience, we expect its government to be working at stimulus programmes that will avert any meaningful slowdown.

Owing to the nature of a one-party government. Its policies can afford to be long term with less interest in shorter-term wobbles.

President Xi has dug in his heels over certain aspects of its alleged violations of Intellectual Property law. He will meet US president Trump at the end of June in the Tokyo G-20 summit but we are no longer hopeful of a quick resolution to ongoing trade tension between the world’s two largest economies. On the other hand, President Trump cannot afford a global or US slowdown so some sort of deal must be cobbled together this year.

US

The US increased tariffs on many imported goods from 10% to 25% as they had foreshadowed. However, President Trump made a last-minute decision to hold off on the auto tariffs’ increases for six months as they would really have hurt Japan and Europe.

The unemployment rate came in at the lowest since December 1969. At just 3.6%, anyone predicting a recession anytime soon must have a very different crystal ball! US wages were up 3.2% which is well above its price inflation rate. There is fat in the economy to shed long before any real problems can emerge.

President Trump needs a strong economy going into the November 2020 elections. Four years of strong growth – against popular opinion in 2016 – will promote his chances of a second term in office. Since a sitting president cannot be tried in the federal courts, Trump has an extra incentive to win next year!

Europe

At last, UK prime minister Theresa May has fallen on her sword. She was gifted the unenviable task of negotiating Brexit. In the recent European Union elections Nigel Farage, one of the architects of the Brexit movement and now leader of the Brexit party, polled very strongly in the UK indicating gaining substantial grass roots support from UK voters. 

Indeed, in the rest of the European elections there was a significant move to parties leaning towards breaking up the union. A so-called hard-Brexit (meaning the UK leaving without a deal on October 31st) is now more probably given the results of the EU elections.

UK economic growth was the best since 2017 at 0.5% for the quarter. After Trump visits in the first week of June to meet with departing Prime Minister May and the Queen, Theresa May will leave office on June 7th.

Rest of the World

The Ukrainian comedian who swept into office a few weeks ago has already called a snap election to get out quick and return to his TV career.
India posted an impressive rate of inflation at 2.9% while its prime minister, Narenda Modi, was re-elected in a landslide.