Key events of the past week and implications

  • The past week saw sharp falls in share markets from mid-week triggered by a combination of worries that the US Federal Reserve (the Fed) will prematurely slow down its quantitative easing program, a softer than expected manufacturing conditions PMI in China and worries that a back-up in Japanese bond yields will hamper efforts to boost the Japanese economy. Reflecting their huge gains over the last six months, Japanese shares were the most volatile, declining 7% on Thursday alone. Australian shares were also hard hit as defensive high yield stocks continued to correct. Over the week, US shares fell just 1.1%, Eurozone shares fell 1.6%, Japanese shares fell 3.5% and Australian shares lost 3.8%. Chinese shares were basically flat with a 0.2% gain.
  • After huge gains over the last year and particularly since mid-April, shares had become very overbought and due for a correction. This was particularly the case for Japanese shares. This market has risen 80% over six months and 45% for the year to date and has become everyone’s favourite to overweight. Similarly, the expensive defensive high yielding stocks, such as banks and telcos in relation to the Australian share market, had also become vulnerable. The events of the last week seem to have just provided a trigger for a correction, rather than representing a dramatic deterioration in the outlook and pointing to a new major slump.
  • It’s worth noting that the correction over the last week was very different to the global growth scares seen around mid-2010, 2011 and 2012. This time around there hasn’t been a peep out of Europe and bond yields rose rather than fell over the last week, which was the case in the prior three years. In other words, this time around it’s more about nervousness as to when the Fed might change direction and not about a possible slump in global growth.
  • Our assessment is that Fed Chairman Bernanke's congressional testimony and the minutes from the last Fed meeting indicate no intention to soon slow the pace of quantitative easing (QE). The markets took a negative lead from Bernanke's comment that he is prepared to slow the pace of QE “in the next few meetings” but this was conditional on seeing a continued improvement in the labour market and increased confidence that it is sustainable. At present, Bernanke and the majority of the Fed lack that confidence with Bernanke seeing only “some” improvement in the labour market and describing it as “weak overall” and warning against a premature tightening of monetary policy. Overall, there is nothing in Bernanke’s comments or the minutes to change our view that the Fed won’t commence a slowing in the pace of QE until around September at the earliest. And when it does, it will only be because the US economy is a lot stronger and the improvement has become selfsustaining.
  • Some have expressed concern that the Bank of Japan (BoJ) did not do anything about a back-up in Japanese bond yields and then later in the week when BoJ Governor Kuroda said he had already announced sufficient stimulus. Our assessment is that for now the BoJ has done enough, but that this doesn’t mean that it won’t do more if required. And in terms of the back-up in Japanese bond yields, the reality is that if the BoJ is successful in achieving 2% inflation and stronger growth then bond yields will have to rise and my assessment is that bond investors are simply pricing in some chance that it will be successful. There is little the BoJ can do about this anyway. So far the sell-off in Japanese Government bonds looks a bit like what happened in 2003 when they went from a low of 0.43% to 1.6% in three months.
  • China’s Purchasing Managers’ Index (PMI) suggests business conditions were weak and points to downside risks for growth, but it’s still in the same range it’s been in for the past two years and is consistent with growth of around 7.5%. What’s more, the flash PMI released in the US was little changed and in the Eurozone, PMIs actually improved.
  • Australia also saw some bad news with Ford announcing it will stop manufacturing cars in October 2016. This is clearly bad news for confidence at a time when the economy needs non-mining industries to pick up and fill the gap left by slowing mining investment. It is terrible news for the workers affected, although it’s worth putting in perspective as it is really just the continuation of a long term decline in manufacturing in Australia. Fifty years ago, manufacturing employed just over 25% of the workforce. Now it has fallen to just 7% as manufacturing has progressively shifted to lower cost countries and we have gone on to do other things. The best thing we can do if we want to see an Australian car industry continue is to buy an Australian car!

Major global economic events and implications

  • In the US, home sales and house prices saw further gains confirming that the housing recovery is continuing, durable goods orders rose more than expected, the preliminary Markit PMI for May fell only slightly and at 51.9, remains at a reasonable, not too weak/not too strong level. Jobless claims also fell.
  • The stronger than expected gains in preliminary business conditions PMIs in Europe are good news and add to confidence the recession there may be weakening.

Australian economic events and implications

  • Australian data was poor, with a sharp fall in consumer sentiment for the second month in a row suggesting that a negative reaction to the Budget has swamped any positive impact from the most recent interest rate cut and another fall in skilled job vacancies suggesting the labour market remains weak. With the Reserve Bank of Australia (RBA) monthly meeting minutes confirming it retains an inclination to cut rates again, our assessment remains that it will have to act on this again soon. While the fall in the A$ is welcome, it hasn't fallen enough yet to allow for the RBA to stop cutting.

Major market moves

  • Share markets had a rough ride with worries the Fed might take the punch bowl away too quickly, soft Chinese manufacturing data and uncertainty about Japanese bond yields providing triggers for a correction.
  • Australian shares have taken their lead from falls in global markets but have underperformed significantly, thanks to a combination of a correction in bank and telco stocks which had become expensive after their huge run-up and foreign investors staying away until the dust settles in relation to the A$.
  • Commodity prices mostly fell and the A$ continued to slide.
  • Bond yields rose and were not helped by fears of a slowing in the Fed’s QE program.

What to watch over the next week?

  • In the US, expect further gains in house prices (Monday) and pending home sales (Thursday). Data for consumer sentiment and personal spending are also due along with an update of March quarter GDP growth.
  • In the Eurozone, business and consumer confidence data will be released Thursday and are expected to confirm the modest improvement seen in the business conditions PMIs.
  • Japanese data to be released on Friday for manufacturing conditions and household spending are likely to show further signs of improvement, but it’s probably too early to expect consumer prices data to show fading deflationary pressures.
  • In China, the official manufacturing conditions PMI (Saturday) will be watched closely to see whether it follows the flash HSBC PMI in falling below 50.
  • In Australia, the big focus will be on March quarter private capital expenditure data (Thursday) as a guide to whether mining investment has peaked and to what extent, if any, non-mining investment can start to fill the gap. While business investment is likely to have seen modest growth in the March quarter, investment intentions for the year ahead are likely to confirm that mining investment has peaked and that non-mining investment is likely to remain weak. Meanwhile, expect a 2% bounce in building approvals (Thursday) after a fall in March, while growth in private sector credit (Friday) is likely to remain modest.

Outlook for markets

  • Shares have been vulnerable to a correction for a while now and this seems to be now kicking in. Over the short term, it could have further to go. We have now entered a seasonally weak period of the year for shares and uncertainties about China plus conjecture over when the Fed will start to slow quantitative easing will weigh on market sentiment in the short term. However, we remain of the view that any setbacks will be mild, say 5-10% rather than the 15-20% falls seen around mid-2010 and mid-2011. Shares are far from expensive, monetary conditions are very easy, the gradually strengthening global growth outlook points to stronger profits ahead and the chase for yield and better returns in the face of low interest rates will likely see ‘buy on the dips’ demand from investors. Increased mergers, buybacks and dividends will also help. So by year-end we see further upside in global and Australian shares.
  • The falling A$ will likely be an additional drag for Australian shares in the short term as foreign investors will hold back until it has stabilised, but longer term it will be a big positive, as in combination with lower interest rates, it will provide a strong boost to profits.
  • Sovereign bonds remain fundamentally vulnerable as an improving global, and ultimately Australian, growth outlook will likely see bond yields move higher over the year ahead, resulting in capital losses for investors.
  • While last year’s low for the A$ around US$0.96 may provide some short term support and it is very oversold technically, with commodity prices now in a downtrend and the outlook for the Australian economy deteriorating relative to the US economy, it’s likely that the A$ is headed much lower. Given its overvaluation in terms of relative prices and costs, it wouldn’t be at all surprising to see it head towards US$0.80 over the next few years.

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