Investment markets and key developments over the past week

Share markets pushed higher over the last week helped by better than feared US earnings results, good economic data and a continued unwinding of disaster fears from early this year. US shares rose 1.6%, Eurozone shares gained 4%, Japanese shares rose 6.5%, Chinese shares rose 3.1% and Australian shares gained 4.5%. The US share market is now up 1.8% year to date. The “risk on” tone saw bond yields and commodity prices (except gold) rise with even the iron ore price making it back to around US$60/tonne. While the US dollar rose slightly, the Australian dollar pushed back to around US$0.77, helped by stronger commodity prices and Australian data.

Surprise, surprise – the IMF has downgraded its global growth forecasts yet again to 3.2% for this year from 3.4% and to 3.5% in 2017 from 3.6% - adding to headline concerns about the global growth outlook. But just bear in mind that the IMF is just catching up to investor concerns that drove the financial turmoil early this year and, in any case, the IMF has been perpetually downgrading its growth forecasts for years now (see the chart below). Invariably the IMF starts off forecasting global growth for the year ahead to be around 4% and then progressively revises it down to around 3%. In other words the latest IMF growth downgrades are nothing new.

Source: IMF, AMP Capital

More significantly, a lot of the fears that drove markets lower earlier this year are still receding:Chinese economic data is looking healthier; those that really matter at the US Federal Reserve (the Fed) are continuing to indicate that it will be cautious and mindful of global conditions in raising interest rates; the US dollar has come off the boil relieving pressures on emerging markets; the Chinese renminbi is proving to be stable on a trade-weighted basis; and fears around Eurozone banks appear to be fading.

A long anticipated meeting between OPEC and Russia in Doha ended without any agreement to freeze oil production, as Saudi Arabia insisted that any freeze must include Iran which didn’t attend the meeting. This was always a high risk as Iran was most unlikely to participate, as it’s still recovering from sanctions. So, after rallying strongly from its February low, expect a short-term knee jerk pull back in the oil price in reaction, with a flow-on to other risk assets including shares. However, regardless of the outcome of the meeting, it does look as if the global oil market is gradually heading back towards balance, as production is being cut elsewhere including in the US which should help the oil price continue to stabilise.

It’s coming up to Budget time again in Australia (3 May) and, as always, everyone is having their say, including the ratings agencies. The perpetual delay in returning the budget to surplus (see next chart) has not threatened Australia’s AAA sovereign rating so far, but comments by Moody’s expressing scepticism about the limited scope for meaningful spending cuts or tax reform suggest that ratings agencies may be losing patience. Despite a commitment from both sides of politics to return to surplus it’s hard to be optimistic about spending cuts unless the government faces a more cooperative Senate and meaningful tax reform looks dead in the water (again). However, there is some reason for optimism in that the cycle of each successive budget update pushing out the return to surplus may not be repeated in the May Budget, as a higher iron ore price (it’s now around US$60/tonne versus the mid-year economic and fiscal outlook assumption of US$39) and stronger employment growth provide a bit of a boost to revenue. This is all about “parameter” changes though and the absence of an improvement in the structural deficit may continue to test the patience of the ratings agencies, so the risk to the AAA rating may still rise. Would a downgrade to AA1 really matter? The experience of other countries suggests the impact on bond yields would be limited but it could boost private sector borrowing costs marginally. And it would be a blow to the national psyche and a sad outcome, given that it took 16 years to regain the AAA rating after it was last lost in 1986.

Source: Commonwealth Treasury, AMP Capital

Major global economic events and implications

US economic data was mixed but okay. Jobless claims fell to their lowest since 1973 (the year Elvis appeared via Satellite from Hawaii). Retail sales were softer than expected in March but previous months were revised up so this is not so bad. Industrial production fell more than expected in March but manufacturing conditions improved in the NY region, small business confidence fell and inflation readings were weaker than expected. Weak inflation readings support Fed Chair Janet Yellen’s caution regarding signs of a pick-up in inflation and give it plenty of scope to go easy in raising rates. March quarter profit reports are off to a good start with 81% of results so far beating on earnings and 61% beating on sales. However, its early days with only 33 S&P 500 companies having reported! Market expectations remain for a 9% yoy fall in earnings for the March quarter, but it’s likely to come in a bit “better” at around -5%.

The trickle of data suggesting Chinese growth is stabilising or improving has now become an avalanche. Chinese GDP growth for the March quarter slowed, as expected, to 6.7% year, reflecting the weak start to the year. But the list of data showing stabilisation or improvement in March expanded further to include: PMI’s, producer price inflation, exports, imports, electricity consumption, railway freight traffic, industrial production, retail sales, fixed asset investment and total financing. The bottom line is that the incremental stimulus measures of the last year or so are now helping growth. This in turn is being reflected in a stronger tone in commodity prices.

Australian economic events and implications

Australian data was surprisingly strong with solid February gains in housing finance for both owner occupiers and investors, a surge in business conditions to an eight year high and stronger business confidence according the NAB business survey. Better than expected jobs growth pushed the unemployment rate down to 5.7% in March. It’s not all positive though as consumer confidence fell again in April to be well below its long-term average. Trend monthly employment growth has slowed to around 8,000 a month from a high point of around 30,000 a month last year and hours worked are slowing. However, the fall in unemployment looks like a trend and it’s hard to see the RBA easing against this backdrop, therefore a May rate cut looks unlikely. However, we continue to see a rate cut as likely for later this year to support growth, particularly if the Australian dollar remains strong at a time when the contribution to growth from housing is slowing, the slump in mining investment is continuing, inflation remains around 2% or below and banks continue to implement out-of-cycle rate hikes.

According to the RBA’s latest six monthly Financial Stability Review the actions of regulators have led to reduced risks around housing lending but there are risks around apartment developments (notably in inner city Melbourne and Brisbane and increasingly Perth), some commercial property markets and around resource related companies. The bank’s exposure to the resources sector is low though and risks around non-resources businesses are low.

What to watch over the next week?

In the US, the key focus will be on March quarter earnings reports which will ramp up over the week ahead. On the data front expect to see a slight rise in the NAHB’s home builders’ index (Monday), a slight fall in housing starts (Tuesday) after a big gain in February, gains in home sales (Wednesday) and home prices (Thursday) and a further slight rise in the manufacturing conditions PMI for April (Friday). The New York Republican primary with 95 delegates is on Tuesday.

In Europe, the ECB (Thursday) is unlikely to unveil further changes to monetary policy given the significant additional easing it announced in March but post-meeting comments will no doubt be watched as a guide to how its seeing the Eurozone economy proceeding. Business condition PMIs for April (Friday) are expected to show a slight improvement.

In Australia, the focus will no doubt be on the minutes from the last RBA Board meeting and a speech by RBA Governor Glenn Stevens (both Tuesday) for any clues on the outlook for interest rates. The Governor’s speech will perhaps be of more interest as it’s timelier. While the RBA is likely to retain its easing, recent data is likely to have added to its comfort regarding the rebalancing of the economy. Skilled vacancy data will be released Wednesday.

Outlook for markets

Expect short-term share market volatility to remain high as we head into May (“sell in May and go away, come back on St Leger’s Day”) and the Fed eventually starting to soften markets up for another rate hike. However, beyond near-term volatility, we still see shares trending higher this year, helped by a combination of relatively attractive valuations compared to bonds, further global monetary easing and continuing moderate global economic growth.

Very low bond yields – with 25% of the global sovereign bond index now having negative yields - point to a soft medium-term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity, weak commodity prices and low inflation. Bonds in higher yielding countries like Australia, the US and maybe even China are relatively attractive.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search by investors for yield.

National capital city residential property price gains are expected to slow to around 3% this year, as the heat comes out of Sydney and Melbourne. Prices are likely to continue to fall in Perth and Darwin, but price growth is likely to pick up in Brisbane.

Cash and bank deposits are likely to continue to provide poor returns, with the RBA expected to cut the cash rate to 1.75%.

The ongoing delay in Fed tightening and stronger data in Australia pose further short-term upside risks for the Australian dollar. However, any further short term strength in the Australian dollar is unlikely to go too far and the broad trend is likely to remain down, as the interest rate differential in favour of Australia narrows as the RBA eventually resumes cutting the cash rate and the Fed eventually resumes hiking, commodity prices remain in a secular downswing and the Australian dollar undertakes its usual undershoot of fair value.