The rally in risk assets stalled as despite a strong earnings season to date as political risks flared up and valuations look stretched following the strong rally over the first quarter of the year.
The S&P/ASX 200 outperformed the rest of the world, up over 1% in the past four weeks as the Reserve Bank of Australia’s (RBA) dovish comments boosted equities. In the U.S., the S&P 500 is down 0.5% after recently making new all-time highs. The Euro STOXX is down 1% in the same period and the Chinese CSI 300 index pulled back nearly 12% following its recent blistering run. Commodities also fell across the board due to the risk-off sentiment.
Defensive assets rallied as government bond yields fell. The U.S. 10-year yield fell 4 basis points (0.04%) to 2.46% despite markets being disappointed with the U.S. Federal Reserve (Fed) reiterating that they are unlikely to move rates in either direction in the current environment. Meanwhile, Australia outperformed again with 10-year yields continuing to make new all-time lows, falling 18 basis points (0.18%) to 1.72%.
The Australian Dollar fell to 69.7 US cents, dropping below the 70 US cents mark.
The RBA was on hold yet again despite some speculation for a cut as the prior RBA minutes revealed that there was now a bias to reduce interest rates. If inflation remains below target and employment weakens, the RBA would move to cut rates, making it clear that the hurdle is the labour market as inflation has been far below targets for a while. The last inflation reading was a weak 1.3% year on year. The labour market data remains mixed and employment figures have been alternating between strong and weak months.
The U.S. economy remains strong, with the unemployment rate hitting the lowest level in 50 years at 3.6%. GDP figures came in far above expectations while consumer spending and retail sales also drove optimism and offset weaker activity indices. The Fed also reiterated that it is unlikely to cut rates in the current environment which disappointed the markets that were hoping for further dovish comments.
Economic data elsewhere were not optimistic, with European data continues to indicate slowing growth, whilst Chinese data was weaker than expected though still in growth territory.
Political tensions flared up again as Trump tweeted that he was unhappy with the progress of trade talks, threatening to implement the previously announced increase in tariffs from 10% to 25% on $200 billion worth of goods by 11 May and potentially levy a tariff on all Chinese imports, despite having repeatedly posting that talks were progressing well. Iran tensions also escalated as the U.S. raised military presence in key areas whilst Iran increased stockpiles of uranium.
Politics remains the headline risk as reporting season has been better than expected, with U.S. earnings now expected to eke out some growth versus just before the start of reporting season when earnings growth was expected to contract for the first quarter in more than 2 years.
Will Australian rates be cut?
The likelihood of a rate cut by the RBA has been rising over the past few months. The market is currently pricing a 20% chance of a cut at next months meeting, 90% by August and are fully pricing in a cut by September this year.
There is no doubt that the Australian economy has weakened over the past couple of years as Chinese growth moderated, hitting exports, whilst property and construction has deteriorated. Speculation had been mounting that a rate cut was due. In April’s RBA meeting minutes, the hurdles for a rate cut were clarified to be inflation and employment.
The inflation target of 2% to 3% over the medium-term has been elusive since 2014, and inflation has been weakening since late 2018 as the chart below shows. If the RBA was only considering inflation, it is likely that they would have cut rates earlier.
The labour market hurdle does not have such a clear target. The RBA’s objective is for ‘full employment’ with no range specified. The current unemployment rate of 5% is right in the middle of what has been the common convention of full employment which is 4% to 6%. The labour market has been strong over the past few years and the unemployment rate has been falling as per the chart below.
Pleasingly, the fall in unemployment has been due to higher full employment figures which is generally considered to be higher quality data versus part-time employment. The issue here is that leading indicators for the labour market have been weakening. The ANZ Job Advertisements numbers have historically inversely led the unemployment rate. The fall in job ads, as shown below, points to rising unemployment rate if the historical relationship is maintained. With construction languishing, it is hard to see the labour market maintaining its strength as the third largest employment sector goes in reverse.
It is clear from the RBA meeting minutes that the labour market is the final straw, “…the Board will be paying close attention to developments in the labour market at its upcoming meetings.” Based on the information above, it is likely that the market is right and the RBA will cut rates within the next few months. The next questions are how many rate cuts will be required for the cycle to turn, and will a quantitative easing program be required? It is likely that, with the rate already at record lows of 1.5%, the impact of one or two 0.25% cuts may be negligible, and more significant measures may be required.
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