Market Commentary – January 2020

Investment markets and key developments over the past week

The solid rally in share markets since the beginning of the year continued this week, with both US shares (up by 2% over the week) and Australian shares (+1.9% this week) hitting record highs as investor optimism lifted on good US and China data and the signing of Phase One of the US/China trade deal. Eurozone stocks also had a good rally (+0.5%) along with Japan (+0.8%), but Chinese shares lagged behind and were down 0.2%. US 10 year yields are tracking at just over 1.8% and have room to lift further in the near term. Oil prices have settled at around US$65/barrel and iron ore prices are rising again around US$95/tonne on fears of cyclone season potentially disrupting exports from Port Hedland in Australia. The US dollar rallied by 2% this week and the Australian dollar tracked sideways, finishing just under 0.69 US dollars.

The US and China signed a formal trade agreement, formalising “Phase One” of their trade talks (for those interested in the specifics, view the official document here). There weren’t too many surprises in the deal, with the main areas covered including:

• Intellectual property rights protection and fair market access;
• More rights for transfer of technology;
• Market access for financial services;
• Refraining from currency manipulation (with the US removing China from its list of currency manipulators this week, but replacing it with the Swiss Franc);
• Expanding trade with China to import at least an additional US$77bn from the US in 2020 and US$123bn in 2021 (from 2017 levels) for manufactured goods, agriculture, energy and services, which will partly shrink the US/China trade deficit and cause some narrowing in the China trade surplus (see the following chart).

While there is some scepticism around China’s ability to be able to achieve the targeted level of US imports over 2020/21, we think it is achievable, as there will be some recovery in US market-share in 2020, as some exports were lost to China in 2019 due to the trade dispute and the value of Chinese imports will grow organically with higher nominal GDP. This leaves around 15% of Chinese imports in 2020/21 that will need to be specifically targeted to US goods and services, which looks achievable. There will be some negative impact to the rest of the world from the redirection of trade. For Australia, the key risks are around agriculture exports and LNG.

It remains to be seen how this agreement addresses the many US grievances. There is no third party arbitrator in this agreement, so either side could find each other at fault at any point in time. Further, there are still more areas around trade that need to be addressed such as Chinese hacking of US businesses and government institutions or around Chinese state subsidies which assist its export companies, which are likely to be included in “Phase Two” talks. Therefore, we believe trade talks will remain a sticking point for markets in 2020.

Although the US agreed to reduce the rate of tariffs on some products in December, tariffs remain in place on nearly three-quarters of Chinese imports to the US. The effective US tariff rate in 2020 is around 5.2% (on all US trade) which is around 0.5% lower than in 2019, but well above the 1.7% 2017 tariff rate before the trade dispute started, so the pain on US importers and consumers (along with the Chinese economy) will still continue. For businesses considering production lines and supply chains, it does little to provide complete clarity around future trade channels, but at least trade talks aren’t breaking down, so we take it as a positive for sentiment.

We don’t expect much further roll-back in tariffs from those already announced in December (a halving in the 15% tariffs put in place in September, which will start in February) for a while, with some news reports this week that current tariffs will remain in place until after the US election. Keeping pressure on China may be a tactic used by President Trump to gather more support pre-election, as it would suggest that he is the only one that can get the negotiations done.

The US House of Representatives voted to refer Trump’s impeachment article to the Senate. We have previously written that the Republican-controlled Senate is unlikely to find Trump guilty. The bigger issue is that the start of the impeachment trial could take away Senators Bernie Sanders and Elizabeth Warren, who are both key potentials for the Democratic nomination, as well as Amy Klobuchar and Michael Bennet, who are also in the running (but less likely to be the Democratic nominee).

The US fourth-quarter reporting season got underway this week with reporting from some of the major banks and so far earnings growth looks decent. The consensus is for a small decline in quarterly profit growth, but earnings to show a small rise over the quarter. We see earnings up by around 2-3% a year ago.

Major global economic events and implications

US broad inflation pressures remain well contained. Growth in core consumer prices was up by 2.3% over the year to December while core producer prices were 1.1% higher. Along with some slowing in average hourly earnings growth, this shows that there is room for the US Federal Reserve to cut interest rates again if required. While we don’t see another US rate cut, the market is pricing in the small chance of this. The NFIB small business confidence index fell back in December and was relatively unchanged over 2019 after solid increases in 2018 (see chart below). Consumer confidence has been tracking sideways recently, although the US consumer remains in good shape, with retail sales growth up by 0.3% in December. The US housing market picture is mixed, with stronger housing starts for December but lower than expected building permits. Lower interest rates should assist the housing market in 2020.

Chinese data was strong and indicated some improvement in growth momentum. December quarter GDP data showed annual GDP growth of 6%, in line with the 6-6.5% growth target. Industrial production growth rose to 6.9% year-on-year to December, retail sales were up by 8% and fixed asset investment increased by 5.4% year-to-date. Chinese credit growth remains solid, with M2 (or broad money) supply up by 8.7% over the year to December, from 8.2% previously. Trade data showed strong growth in exports over the year to December (+7.6%) and imports being up by 16.3%, beating expectations.

Australian economic events and implications

November housing finance data showed that the value of housing lending to owner-occupiers (ex-refinancing) was up by a solid 1.8% in November, with a large rise in investor lending.

What to watch over the next week?

US manufacturing and services PMI’s for January will be released – the best leading indicator to business activity. Manufacturing conditions weakened in the US over 2019, but the PMI has been holding up much better than the ISM because of the broader scope of the survey. Manufacturing conditions are expected to start improving in the US.

The European Central Bank meet next week and no changes are expected to the central bank’s current quantitative easing program of €20bn/month or its current interest rate settings. Monetary policy is expected to remain easy in the eurozone over 2020. January manufacturing and service PMI’s are also released and should show a stabilisation in activity.

In Japan, December consumer prices are released, which are expected to show that inflation remains less than 1% per annum, below the Bank of Japan’s 2% target.

In Australia, the December job data should show lower job growth, around 8-10K over the month with the unemployment rate remaining at 5.2%, which indicates some underutilisation. January consumer sentiment data is likely to take a hit from the bushfires over recent months.

Outlook for markets

Improving global growth and still easy monetary conditions should drive reasonable investment returns through 2020, but they are likely to be more modest than the double-digit gains of 2019, as the starting point of higher valuations for shares and geopolitical risks are likely to constrain gains and create some volatility:

• After very strong gains and with investor sentiment now bullish, shares are due for a short-term correction or consolidation.
• However, for the year as a whole, global shares are expected to see total returns around 9.5%, helped by better growth and easy monetary policy.
• Cyclical, non-US and emerging market shares are likely to outperform, particularly if the US dollar declines and trade threat recedes as we expect.
• Australian shares are likely to do okay this year, but with total returns also constrained to around 9% given sub-par economic and profit growth.
• Low starting point yields and a slight rise in yields through the year are likely to result in low returns from bonds.
• Unlisted commercial property and infrastructure are likely to continue benefitting from the search for yield, but the decline in retail property values will still weigh on property returns.
• National capital city house prices are expected to see continued strong gains into early 2020 on the back of pent up demand, rate cuts and the fear of missing out. However, poor affordability, the weak economy, and still tight lending standards are expected to see the pace of gains slow, leaving property prices up 10% for the year as a whole.
• Cash and bank deposits are likely to provide very poor returns, with the Reserve Bank of Australia (RBA) expected to cut the cash rate to 0.25%.
• The Australian dollar is likely to fall to around $US0.65 as the RBA eases further, but then drift