Apart from the usual â€œgeo-politicalâ€ risks that persistently swirl around financial markets, the fortunes of investors typically turn on more mundane macro-economic forces such as growth and inflation.
Heading into 2018, Iâ€™ve tried to identify the key economic issues which will have the most bearing on the local stock market. Iâ€™ve tried hard to keep the list manageable. Indeed, Iâ€™ve indentified three key factors.
Firstly, is the performance of the Australian economy itself. On this score, I donâ€™t think we can anticipate any major change in the still relatively soft outlook for mining investment. And while the outlook for non-mining investment (i.e. in factories and offices) is improving, itâ€™s unlikely to ramp up quickly this year. Instead, the main swing variable will be housing construction.
Although home building approvals appear to have passed their peak, itâ€™s fair to say theyâ€™ve not so far slumped in the way many (including myself) have feared â€“ indeed, they continue to show feisty resistance, as evident by the 11.7% rise in approvals in November reported yesterday, driven by another 30% surge in (volatile) approvals for apartments. Housing is unlikely to be a major contributor to growth or employment this year, but the economyâ€™s downside will be protected is we can stave off the enviable building decline for at least another year. So far so good.
Another key swing variable for the economy will the fate of consumers. Again despite persistent hopes, I suspect wage growth will remain quite soft this year and house prices will be lot flatter â€“ meaning household income and wealth perceptions will again be challenged.
Household Saving Ratio
Whether households keep spending- which is critical for the economy given this accounts for just over half of GDP â€“ will in turn depend on whether they can keep running down their saving ratio. As evident in the chart above, consumer spending would have been a lot weaker in recent years were it not for reduced saving, but by late 2017 it appeared householdâ€™s recourse to this means of spending has been tapped out. What happens to the saving ratio in 2018 will be critical â€“ my hunch is that it will flatten out, which will keep consumer spending relatively subdued.
Globally, perhaps the single biggest swing variable will be US wage inflation. Again momentum in the US economy remains fairly strong, and itâ€™s likely the already low unemployment rate will ratchet down further â€“ probably to below 4%. Whether the party can last will depend on whether this apparent labour market tightness leads to an upsurge in (still relatively dormant) wage inflation, which in turn would make the US Federal Reserve more aggressive about raising interest rates. A pick-up in inflation driven by capacity constraints is the greatest threat to the impressive US economic expansion and equity bull market.
My hunch is that we will see a moderate lift in US wage inflation â€“ with annual growth in average hourly earnings rising from around 2.5% to 3% by yearâ€™s end. But that should still only support three to four US rate hikes, which wonâ€™t be enough to kill the economy. Higher wage growth meanwhile â€“ implying better balanced income growth â€“ should also support US consumer spending.
Last but not least is the outlook for iron ore and coal prices. Oddly enough, prices have been sustained over the past year by Chinaâ€™s attempt to clamp down on steel production, due to excess capacity and excess pollution. Given persistent underlying steel demand, this has boosted steel prices and the profitability of those Chinese producers who manage to avoid bureaucratic shutdown. Itâ€™s also supported demand for higher quality imported resources, such as from Australia.
How this dynamic plays out in 2018 remains to be seen. But to my mind, it still seems likely the overall negative demand effect of Chinaâ€™s steel slowdown will eventually outweigh the current positive â€œsubstitutionâ€ effect of cleaner Australian resource inputs replacing Chinaâ€™s dirtier local alternatives. That said, Iâ€™m no longer anticipating a major commodity price slump â€“ rather an easing back in iron ore prices, for example, from current level of $75/tonne to $US 50-55. Along with still rising production volumes and lowered costs, that should still mean local miners can punch out decent profits.
Overall, I remain optimistic the mix of these variables can keep global equity prices aloft this year, but Australiaâ€™s market may well not be among the global leaders once again.
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