Economic Update – January 2020

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

Optimism for share markets in 2020.

– Equity markets offer good growth and yield opportunities
– US-China tariff deal could be big news
– Clarity over Brexit gives more growth prospects.

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 office.

The Big Picture

Before we launch into our set of predictions for 2020 and beyond, it is worth reflecting on the decade that just ended.

The ASX 200 started the decade at 4,871 and it ended at 6,684 – or 37.2% higher. That amounts to an annual growth rate of 3.2%. Not great but it beat cash. When dividends are included, the growth turns out to be 113.2% or 7.9% pa. Of course, many Australian residents also received franking credits possibly adding over 1% pa to that growth.

Along the way, investors had to duck for cover as many commentators predicted several ‘hard landings’ for China, recessions in the US and the world and numerous other false signals.

The S&P 500 did even better than the ASX 200. It started the decade at 1,115 and ended it at 3,231 for a growth of 189.7% or 11.2% pa. With dividends, that growth rate rises to 13.6% pa. Of course, Australian investors may have also benefited from the 22% fall in our currency over the decade depending on how their overseas investments were managed.

We are still positive for equities going into 2020 but there are some false signals that need to be considered. Capital gains in both indexes were very strong in 2019 [ASX 200, +18.4%; S&P 500; +28.9%] but here the context is important. The US Federal Reserve (“Fed”) frightened markets in early October 2018 sending markets sharply lower. It so happens that the reaction was unnecessary as the Fed reversed its comments over the following months. The markets bottomed around the end of 2018 so the 2019 gains included ‘fundamental’ growth plus the correction of the earlier over-reaction.

Our estimates put the actual fundamental growth in 2019 at only a little over average rather than stellar. Our forecasts for both markets in 2020 are again just above average (before dividends). With bond yields and cash rates expected to continue at around the current low levels, equities are likely to be about the only way to earn both yield and growth in 2020.

Every year produces market surprises which are unpredictable. However, we can suggest some other possible sources of known possible surprises and whether these are more likely to be positive or negative.

The phase 1 deal in the China-US tariff war is likely to be signed very soon and this would be a strong positive for US and global growth if both sides stick to it. With the presidential election in November, Trump is incentivised to keep the deal on track.

The Fed has stated that it will keep rates on hold in 2020 while markets are still pricing in a possible single cut. Certainty in understanding and believing the Fed is always a positive. Our scenario for 2020 is continued low bond yields and cash rates.

The recent landslide victory for Boris Johnson’s conservative party in the UK will almost certainly end the three and a half years of Brexit woes with a clear break from the EU in January. There is plenty of positivity about possible new trade deals with the US, Australia and a temporary deal with Europe. There is no talk of major moves of international banks from London to Europe as were once predicted.

Since Johnson is likely to help the transition with fiscal stimulus, the UK and Europe could be in much better shape in 2020 than the last few years.
China economic data have turned the corner and we expect a solid post-tariff-war growth from China.

Australia remains in sluggish economic times. However, growth and jobs are solid – just not strong. The Reserve Bank is likely to cut its rate again – at least once in 2020.

We will tease out these predictions – and others – in the sections that follow. Unlike in past years, none of the main economic known situations seem likely to be negative for markets – but, of course – there is always the completely unexpected!

Asset Classes
Australian Equities

Big banks suffered later in 2019 over the Westpac money laundering scam and other banking crises. Financials lost 6.0% in the second half of 2019 (H2) while the broader index rose +1.0%. Telcos losses were even worse than Financials with a loss of 8.2% in H2.

The banks are currently cheap but uncertainty over possible future revelations makes heavy investment in them bold to say the least.

All sectors had a bad last two days of 2019 but that is more likely attributable to profit taking and accounting creativity at year end. There was no bad news to speak of and volumes were low. Materials had a strong December rising +1.5%. The ASX 200 lost 2.4% in December.

Foreign Equities

The S&P 500 is currently overpriced by our measurements. Making our fundamental projected growth (+11%) more like an actual 7% or so when current mispricing is factored in. A year ago, we had mispricing at about 15% which helped fuel the ‘stellar’ headline returns of 2019.

The Health sector of the S&P 500 had a spectacular year in 2019. If the Democrats are elected, that could put downwards pressure on Health stocks. Either way the main gains seem to be behind us.

While the ASX 200 went backwards in December, other major indexes did very well: S&P 500 (+2.9%), FTSE (+2.7%), World (+2.7%) and Emerging (+5.9%).

Bonds and Interest Rates

The Fed was on hold in December and its so-called ‘dot plots’ that represent members’ forecasts showed the Fed to be on hold for 2020 with one increase in 2021 and one more in 2022.

The CME Fedwatch tool that prices possible Fed rate changes off futures prices puts the chances of a ‘no change’ outcome in 2020 at above 50% but this figure moves from day to day. There is little or no support for a hike and one (or possibly two) cuts is expected by the market.

The RBA was on hold in December and does not meet in January. Many, including us, think there is at least one cut left in the RBA. Previous talk of QE by the Bank has subsided but they might do something creative in 2020.

Other Assets

The prices of iron ore, copper and oil all had a very strong month in December. Our dollar appreciated +3.4% against the US dollar taking it back above 70 US cents for the first time in a while.

The Saudis appear to be working hard to get a stable equilibrium price for oil. It has been suggested that the Saudis need the price of oil above about $80 / barrel to balance their budget but Russia can make a profit at $50. Interesting times!

Regional Review
Australia

Our Q3 GDP growth figure came in at the low end of expectations in early December – just after the RBA kept rates on hold.

The quarter on quarter growth was +0.4% which, over the year, turned out to be +1.7%. Since that annual figure was the same as population growth – both natural and through immigration – the per capita growth was 0.0%. Hence, we are going nowhere towards building a stronger economy but, at least, we’re not going backwards!

Our jobs data were quite strong suggesting the quality of the jobs in contributing to growth must have been poor. The unemployment rate fell one notch to 5.2%. A recession does not seem to be on the cards but there is a strong case for the government providing a fiscal stimulus to accompany the work the RBA has at last been doing on rates.

However, for political reasons, the government is wedded to producing budget surpluses. The whole point of fiscal management is to run at a deficit when the economy needs a boost and to pocket the savings when the economy is stronger.

The good news is that the official Australian Bureau of Statistics house price indexes showed a strong bounce in Q3 after a couple of years of falling prices. These data corroborate earlier monthly data released by private agencies.

The house price index went up by +2.5% for the nation in Q3 but about +3.5% for each of Sydney and Melbourne. House price increases are often associated with a boost in consumer confidence through an increased home equity cushion.

China

We reported last month that the Chinese economy started to show signs of weakening. However, the four major economic indicators that we used for that assessment were all strongly up this month and, indeed, were a beat on expectations.

The latest Purchasing Managers Index (PMI) for manufacturing came in at 50.2 for the second month in a row and above the expected 50.1. Manufacturing is not kicking the ball out of the park at just over the 50 level which separates contraction from expansion, but it is growing. The services sector is doing the heavy lifting.
China is removing some of its tariffs on US imports and seems to be embracing the phase 1 trade deal with the US.

In 2020, growth is likely to dip below 6% for the first time in well over a decade. Unlike some, we think that is not an issue to necessarily worry about. In fact, we view it somewhat positively. The context for this view is that, a decade ago, the Chinese economy grew at around 11% p.a. to 12% p.a. But China’s economy has approximately doubled over the last decade so, 6% now is producing the same dollar value increase in GDP that 12% growth achieved a decade ago. The growth rate of all economies slow down as they reach maturity. One day China will grow at rates in the range or 2% to 4% like the US does now – and that will be a good thing for the global economy, all else being equal. Of course, if sub 6% was the result of weak economy rather than a maturing economy, that would be another story – but it isn’t.

US

The impeachment issue has taken up too much space. An impeachment is only the equivalent of an indictment in criminal law. An indictment means that a case for trial has been made. The judge and jury then decide guilt or otherwise – after the case is argued properly.

The impeachment vote went almost along party lines in the (lower) Democrat-held House. All Republicans voted against impeachment but three Democrats crossed the floor to join the Republicans! Since a 60% majority is needed to sack the president in the Senate and the Republicans have a majority in the Senate, it is extremely unlikely that Trump will be sacked.

What is interesting is that Nancy Pelosi, the Democratic leader of the House, is not sending the indictment up to the Senate – at least not yet. She must know she will lose and it is election year. Presumably she has a plan to eke out some political mileage but we do not know what that plan might be.

Many say – and we probably agree – that a sitting President gets elected when the economy is strong. US jobs bounced back strongly last monthly but partly because 46,000 GM workers went back to work after a strike. Either way, the unemployment rate is at the 50-year low of 3.5% and the wage rate increase sits at a reasonable 3.1%.

Now that Trump has the China deal in motion and the new North America Free Trade Agreement (NAFTA) with Mexico and Canada looks set to be implemented, Trump looks to be successful on trade. We do not believe the gains made in these negotiations are great but they are getting the sound bites. There doesn’t seem to be long enough before the election for things to go significantly wrong. Indeed, the trade deals might cause a nice expansion into 2020. There are some people that might not like Trump for a myriad of reasons but he is the poster boy of a strong economy.

If we go back to the 2016 election, a bunch of Nobel Laureates (yes, in economics) said (as we reported at the time) there would be a recession as a result of Trump’s election and his policies. They didn’t actually say when but that ship is taking a very long time to sail, and clearly has not sailed yet.

In mid-2019 many economists (most without Nobel Prizes) argued that because the short-term US interest rate was higher than the long-term interest rate – a so called yield-curve inversion – a recession would follow in 12 to 18 months. That point was laboured in the media for months but now the proponents of that view are scarce.

As we wrote at the time, economic life is far more complicated than looking at a few simple statistics and crying ‘wolf’. Indeed, their thesis on recessions was that an ‘inversion’ is all that is needed – so that the now normal yield curve does not remove that so-called prediction accuracy! If those forecasting a US recession 12 to 18 months after the occurrence of the yield curve inversion were true to their beliefs they would still be arguing for this outcome – but they’re not!

With the Fed and markets at last (more or less) in harmony it is difficult to see anything less than at least a slight boost to the US economy. That, in turn, would mean a boost to company earnings and a boost to the S&P 500. Our forecasts are based on current broker forecasts of earnings, which we use as a directional guide, so we might see further upside in corporate earnings in the coming quarters.

Europe

Readers might recall the media were telling us that the UK electorate was duped over the Brexit referendum. “They didn’t know what they were voting for” and “they will vote the other way if they get a second referendum”. So much for the media! Boris Johnson made Brexit THE election issue and he won with a landslide victory – by 80 seats.

Conservative Party leader Boris Johnson expelled more than 20 disillusioned sitting members before preselection ahead of the ‘BREXIT’ election, in so doing creating a massive united mandate within the Conservative party. We were told from various exit polls that lots of hard-line Labour voters switched to voting Tory by “lending” their votes for Brexit. The implied intention is that these latent Labour voters will return to their grass roots of Labour in five years’ time – after Brexit is locked in. So much for ‘duped’ voters.

It is not for us to judge whether the UK should be in or out of Europe but it is blindingly obvious that the uncertainty has confused investment decision making with respect to the UK and, hence, growth. Trump and Australia seem to be making plans to initiate trade deals with the UK and Europe might now be forced to think that way as well. The CEO of Morgan Stanley, a major international bank, stated publicly that they are not moving any significant numbers of people to Europe from London – a far cry from earlier speculations.

Rest of the World

Japan is launching a $120bn stimulus package as the ‘third arrow’ of the Abenomics initiative when Abe came to power in December 2012. It seems that nothing they do gets inflation working and nor for that matter has any other major economy been successful in creating inflation either.

Christine Lagarde, the new president of the European Central Bank, who reportedly has no training in economics nor experience in banking, has recently stated that she is thinking of changing the inflation target for Europe. While that approach has the appearance of simplicity it has not received meaningful support from leading economists. The concern is that Europe is too big of an economy to let itself off the hook by conveniently moving the goal posts.