It has been another big week for events and data although from a market perspective, much of what we saw this week was already priced in last week.
Aussie equities outperform
For only the second month this year, October saw the Australian equities market outperform the MSCI World Market Index. The ASX200 was up 4.2% in October compared to a 1.7% rise in the MSCI World Index. Aussie equities have been relatively unloved for some time given weaker commodity prices, and "disruption" and regulatory issues in banking and retail. Meanwhile, the economic data have been quietly improving, the RBA is firmly on hold, and valuations look more attractive, particularly given the recent sell-off in Aussie 10-year bonds. Aussie 10-year yields fell 16bpts in October and are now just 31bpts above those in the US.
More broadly, the multi-asset team believe equities remain well supported for three reasons: growth - most global manufacturing surveys are firmly in expansion territory while Asian exports are surging; earnings - strong overall, with beats in the U.S. and Asia overwhelming misses in Europe; and liquidity - news that Powell is set to be the next Fed chair removes the risk of a rapid removal of the punchbowl.
Financial conditions easiest since pre-GFC
Financial conditions in the U.S. haven't been this easy ever – eclipsing the frenzied days of the dot-com boom and pre-GFC peak. Yes, stocks are at records and the VIX is moribund. But corporate bond spreads are narrow while lower rated corporate spreads are at multi-year lows, municipal bond spreads are thin as well, and lastly, swaption volatility barely has a heartbeat. This is one very good reason why the Fed will raise rates in December and why there is currently a near 50% chance priced in for a hike in March next year. No surprise the front end of the US yield curve has been so unloved lately and there may be more to come. The market is currently pricing in just 2 ½ rate hikes between now and the end of 2018, including one in December. This compares with 4 hikes on the Fed's dot plot. Easy financial conditions, if they remain, give the Fed a free pass to keep raising rates.
Some argue, from an inflation-fighting perspective, the Fed and other central banks have little to do. In this environment, if inflation stays lower for longer because of the expansion of the supply side (see below), then bond yields will struggle to move higher and equity valuations can remain elevated. In an inflation targeting world, the Fed should keep rates low.
The only justification for more hikes is for the Fed to tilt more toward focussing on financial conditions - tighten for the sake of safeguarding financial stability. This is the perspective previously taken by the RBA. We will be watching carefully for any clue of such a tilt from the new Fed Chair Jerome Powell when he assumes the role in February.
Desperately seeking inflation…still
There was good and bad news from the retail sales report for September last week. The good news is that Australians are in a buying mood. Quarterly growth in volumes surprised to the upside reporting the largest increase in over eight years. Compositionally volumes growth was mixed across the components, with rise in food, clothing and other retailing more than offsetting the decline in household goods, department stores and cafes & restaurants. The bad news is inflation remains elusive. In value terms, taking prices into account, retail sales disappointed for a third consecutive month in September, remaining unchanged against expectations for +0.4% mom. As a result, the annual rate decelerated sharply to +1.4%yoy – the slowest annual pace since mid-2013. In developed economies, inflation has averaged less since the early 2000s than it did in the second half of the last century. What has happened? China’s accession to the World Trade Organization in 2001 may have had a lot to do with it. In the 10 years before China joined the WTO, inflation in developed economies averaged around 4%. That compares with 1.99% since its accession.