Wealth Managed - 23 May 2016

By David Lane - May 23, 2016

Inflation and the relationship to interest rates has been the hot topic of market participants in recent weeks. With contrary circumstances in Australia and the US, predictions of further cuts in Australia and impending increases in the US are gaining in support.

In Australia, the RBA’s inflation target of 2-3% lead it to cut official rates to 1.75% on 3 May, as our CPI is trending below 2%.  A number of leading economists have since downgraded their forecasts for interest rates in Australia, due to the disinflation currently in the system.  The release of the Monetary Policy Minutes confirmed the Board’s concerns about the impact of inflation below the target range.

In contrast, in the US, the Federal Reserve last week used the same target inflation as the reason for another potential rate rise in the near future.  US CPI data is showing that inflation is just under 2%, but the Federal Reserve has this target firmly in its sights.  In the minutes of the last Federal Open Markets Committee (FOMC), it was highlighted that “In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.”   The minutes did note that they expect that economic conditions will only warrant gradual increases in the federal funds rate, which has gone some to appease markets.  A risk to the performance of investment markets – and asset prices in general – is that rates rise rapidly.  It seems (at least at this stage) that this will not be the case, and that any increases in rates will happen in a measured, well telegraphed manner.

Last week, Macquarie Bank made some significant changes to their Australian Macro Outlook, which impacted their view on the economy, currency and interest rates.  Key amongst the changes were the headline grabbing call that the RBA would need to reduce official cash rates to 1%, and that the Government 10 year bond yield would decline to sub-2%.  These calls come on the back of expectations of lower inflation.  One of the key flow-on impacts of this outlook would be a lower Australian Dollar, particular against a backdrop of rising US rates.

Curiously, though, with such dire predictions, the analysts at Macquarie have not made any dramatic changes to their outlook for the underlying economy, and still expect it to grow.  They have even said that the expectations are for “…Australia’s economy to continue to produce growth that will appear ‘solid’ or ‘strong’ relative to advanced economy peers.”  This view seems contrary to the more subdued views that would encourage more severe downgrades to interest rates.

We do not subscribe to such a negative outlook for the Australian economy.  While there are signs of pressure in certain segments and industries, we have been particularly resilient throughout various economic forces over recent years.  With continued strength in our major trading partners, and domestic industries assisted by a lower Australian dollar, we believe economic growth will be sufficient to return inflation back into the RBA target of 2 – 3%.

News in Review 

  • The dominant driver of equity markets over the last week was the release of the minutes from the US Fed’s FOMC April meeting, which suggested an increased likelihood of a rate hike in June.  
  • Higher energy prices in the US (up 3.4% month on month) helped drive a stronger than expected 0.4% rise in the US headline CPI figure in April, lifting the annual rate to 1.1% year on year from 0.9% in March.
  • In the Euro area, the ‘core’ CPI figure (stripping out volatile food and energy prices) came in at 0.7% on an annualized growth rate, compared to the March reading of 0.8%, leaving the effectiveness of the European Central Bank’s extremely accommodative monetary policies open to scrutiny.  Meanwhile the minutes of the last ECB Council meeting revealed that members were disappointed that measured inflation expectations had not increased with the stabilisation seen in commodity markets.
  • Australia’s April employment report revealed an 11,000 rise in jobs, following a 26,000 rise in the March numbers. The unemployment rate was steady at 5.7%, without edging higher as the market had predicted.  Australia’s wage price index only rose a mere 0.4% quarter on quarter in Q1 of 2016, below market expectations.  The annual wage inflation fell to 2.1% year on year, the lowest level since the index began in 1997.
  • The Australian dollar shot back up above the 73 US cents mark after minutes from the 3rd May RBA board meeting revealed some reluctance by members to cut the cash rate.  Consensus among economists, however, remains for at least one more rate cut in 2016, which was reflected in 10 year Australian Government bond yields hitting their lowest level ever of 2.2%.
  • New house prices in China rose in 65 of 70 major cities in April, up from 62 cities in March. Prices in Shanghai rose an extraordinary 28.1% year on year, 17.9% in Beijing and 17.3% in Guangzhou.  The average price increase was 1.2% month on month, lifting the annual inflation rate to 6.2% year on year from 4.9% previously.
  • Japan’s Q1 2016 GDP growth proved much stronger than the market had expected, rebounding 1.7% following a 1.7% decline in Q4 of 2015.  The growth was largely driven by a stronger than expected rise in private consumption and net exports, and occurred despite a 1.4% quarter on quarter decline in business investment.

Company News

  • Sonic Healthcare has struck a deal with the Federal Government whereby the industry will accept the cuts to the bulk-billing incentive (announced as part of MYEFO) in return for the regulation of excessive collection centre rents.
  • APN News & Media announced plans to de-merge NZME (creating a standalone publishing, radio and digital businesses across NZ) and raise $180m via a 1-for-3 accelerated renounceable entitlement offer.
  • Australia's major banks have recognised the impact of the dairy crisis on clients, announcing short-term relief measures for farmers.   ANZ led the announcements with its "dairy relief package", whereby its dairy clients are able to apply for a three-month suspension of loan repayments, waived loan restructuring fees, adjustments to lending limits on credit cards and early access to term deposits.
  • BHP Billiton and Brazilian miner Vale have started rebuilding towns affected by the Samarco dam disaster.  They are set to rebuild the Brazilian town of Bento Rodrigues at a different location, after the town residents voted to rebuild about 12 kilometres away.  

The Week Ahead

  • US: New home sales change April, Jobless claims.
  • Australia: Construction Work Done.
  • Europe: Manufacturing PMI, Markit Composite PMI.
  • China: CB Leading Economic Index.
  • Japan: Trade balance, National Core CPI

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