The Wrap: CPI, Housing, USD & Commodities

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Weekly Broker Wrap: Implications of Dec qtr CPI; housing downturn but crash unlikely; gold outlook; US dollar strength; and commodity prices in 2017.

-Downside risk emerging to RBA growth and inflation forecasts
-Housing activity seen peaking, developers become cautious and credit tightens
-Uncertainties underpinning gold but upside limited
-US dollar strength likely to ebb after March quarter
-Supply side factors to drive commodity prices in 2017
 

Consumer Price Index

Inflation is uncomfortably low. This is the message brokers take from the December quarter CPI. The trimmed mean CPI rose by just 0.4%, taking the core inflation rate for the end of the year to 1.6%. Headline CPI was also weak, rising by 0.5% and lifting to 1.5% for the year 2016. Fresh produce posted inflation of 5.6% in the quarter while packaged groceries posted deflation of -1.1%. Pricing power remains weak as consumers continue to experience a squeeze in cost of living.

Inflation is below the Reserve Bank's target band of 2-3% per annum across the cycle. The RBA appears prepared for a prolonged under-shooting of its target. Credit Suisse envisages downside risk emerging to the RBA's forecasts in coming quarters. The broker expects the RBA to downgrade official growth forecasts and possibly tweak inflation forecasts to reflect downside risks. This is consistent with more rate cuts, the broker believes.

Morgan Stanley agrees that the RBA is likely to trim its growth forecasts in February. The broker considers Australian growth and fiscal policy are out of sync with developed market peers and, as a result, expects inflation to only gradually recover to the low end of the target band. The broker expects the RBA will be patient with the below-target inflation rate, as strong dwelling price growth continues in Sydney and Melbourne.

Deutsche Bank expects the cash rate to be unchanged at the February board meeting and does not expect revisions to the central bank's broader view on inflation in the following Statement on Monetary Policy. The broker finds few reasons for core inflation in Australia to lift in coming quarters, given the Australian dollar trade weighted index is higher than a year ago and also because wages growth continues to either make new lows or run near record low levels.

The data, plus the broker's supermarket index, indicate that Wesfarmers ((WES)) and Woolworths ((WOW)) are continuing to drive weaker prices through investment, particularly in packaged groceries. On balance, Deutsche Bank expects the RBA to ease the cash rate this year, with the risk around May in terms of timing.

Macquarie notes Australia's inflation outlook is in stark contrast to that of the US, where a tight labour market has meant wages have grown, housing rents are rising. The divergence is likely to persist into 2017 and reinforces the broker's outlook for monetary policies to diverge. The trimmed mean was in line with Macquarie's forecasts, which has diminished expectations for a reduction to official rates in February.

The broker expects the RBA will deliver two additional rate reductions in 2017, with May and August being the key months, while a shift in either the Australian dollar or fiscal policy could alleviate the need for further rate cuts.

UBS notes the 0.5% gain in the quarter shows a clear rebound from inflation in the first half of 2016, only in part because of volatile fruit, petrol & tobacco prices. With an improvement in the economy's macro drivers and fading headwinds across commodities, UBS believes the RBA could be on hold for an extended period and argues against any need to lift rates before mid 2018. Citi also does not expect to receive further weakness in yearly prints on the CPI.

Moreover, the first quarter result in 2017 should be boosted by the fall in the CPI in the corresponding first quarter in 2016, and beyond that even a continuation of soft quarterly growth – at around 0.5% – should be enough to keep headline inflation above the bottom of the target band for most of 2017.

Still, given the economic inertia and low inflation expectations, the broker acknowledges a risk that its forecast of a pick up in inflation to 2% by mid year may not be reached. Citi, therefore, believes any move to price in a partial rate hike by the end of the year is premature.

Housing

Housing activity is now peaking, UBS observes, with housing commencements falling in the September quarter to the lowest level since 2014. The broker believes a multi-decade low in the commencements-to-approvals ratio for multi-unit dwellings suggests developers have become cautious and/or credit has tightened. While a correction is expected, the broker still believes a soft landing will ensue and a typical cycle is now underway.

UBS expects around a -30% peak-to-trough drop in commencements, similar to prior cycles, and that it should not get much worse. Meanwhile, house prices keep rising faster than income, as the RBA's official rate cuts in mid-2016 helped lift loan demand and pushed auction clearance rates to a record high. While the broker expects both commencements and activity to turn down sharply until the end of 2018 the lack of official rate hikes reduces the likelihood this downturn in housing activity will evolve into a crash.

Gold

The yellow metal continues to find support from safe-haven buying along with some near-term weakness in the US dollar. Yet ANZ Bank analysts suggest weakness in the physical market and rising interest rates should keep upside limited in the near term. The economic policy uncertainty emanating from the UK's prospective exit from the EU and President Trump's trade policies should continue to attract investor demand for gold.

This is unlikely to be enough to negate the headwind from increasing interest rates in the US. As a US Federal Reserve becomes more hawkish, the analysts expect US 10-year yields to push towards 3% in 2017. Hence, gold prices are expected to trade in a tight range of US$1200-1240/oz over the next couple of quarters.

US dollar

CIBC analysts believe the US dollar has one more bout of strength available but after the first quarter the currency will underperform as, in the absence of aggressive trade restrictions or greater-than-expected fiscal easing, it should depreciate against a number of major currencies.

The analysts note the surge in the US dollar post the election of Donald Trump has transformed into a sideways trend over the past month. They believe President Trump's protectionist stance will square off against his desire for a weaker currency and, given that the two are incompatible, something will have to give.

At this point, the analysts suggest the more aggressive US rhetoric on trade policy is unlikely to become a reality while fiscal policy is not shaping up to be a major boon for the economy, as more conservative members of Congress are expected to keep a lid on the deficit. As long as Twitter remains the favourite medium for comments on protectionism, and fiscal easing is offset by spending restraint, the analysts look for the US dollar strength to ebb from the March quarter.

Commodities

Commonwealth Bank analysts expect supply-side factors to drive commodity prices this year. Demand should ease as Chinese property construction slows. Prices should also decline as the hype fades surrounding Donald Trump's infrastructure spending plans. The analysts make notable changes to forecasts, including an upgrade to thermal coal prices, as China is targeting a domestic price of around US$65/t. Forecasts for gold are downgraded as markets price in multiple increases in the US Fed Funds rate.

Overall, the analysts consider the picture mixed, as only a mild contraction in Chinese construction activity is forecast. Analysis suggests that nickel and thermal coal prices are exposed to upside risks if global demand surprises on the upside, while China's steel and aluminium sectors are the most vulnerable to supply cuts.

The analysts note producer margins across most commodities currently signal deficit conditions. In some, such as iron ore and traded coal, nearly all suppliers are making cash profits. The analysts suspect a normalisation of margins would imply an end to these deficit conditions at the very least. The analysts expect commodity producer margins to decline throughout 2017 and normalise next year.

They observe there is still a great reluctance among producers to deploy risky capital, as suppliers are cautious about the outlook for the Chinese economy, which accounts for 40-60% of demand for most major mining commodities. While it is hard to call Chinese stimulus and producer reluctance to add supply temporary factors, they are acting to keep margins at elevated levels.

The analysts argue that, a producer's strategy to keep production stable and enjoy higher margins is fundamentally sound if most other producers are doing the same. As a result, a normalisation of margins will be driven by easing demand, an outcome that is dependent on slower Chinese consumption.

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