Key events of the past week and implications

  • Despite concerns about slowing global business conditions purchasing managers’ indices (PMIs), share markets continued to surge over the past week with much better than expected US jobs data providing an additional push to US and European shares on Friday. The Dow Jones index even briefly made it above 15,000 for the first time ever, with the broader S&P 500 up 2% over the week. European shares rose 2.5%, Australian shares rose 0.6% and Chinese shares rose 1.3%. Japanese shares fell 1.1% over the past week, but this followed huge previous gains.
  • The announcement of a new Italian Government, with Prime Minister Enrico Letta declaring a focus on growth, has resulted in a further decline in Eurozone financial risk. While it’s unlikely to be smooth sailing for the coalition led Letta Government, at least the near-term uncertainty has been removed. This has seen a further fall in Italian bond yields with the two-year bond yield at a new record low of just 1.02%. Ten-year bond yields in both Italy and Spain have collapsed to near pre-crisis lows, underlining the continued retreat of the Eurozone crisis.
  • There were no real surprises from the US Federal Reserve (Fed) which left monetary policy unchanged, continuing with $US85 billion of asset purchases a month. However, it did suggest a slightly more dovish tone suggesting the softer tone of some recent data has seen many Fed officials back away from a desire to slow the pace of quantitative easing.
  • Dampening market sentiment mid-week was the confirmation of soft April manufacturing conditions PMIs in the US, China, the Eurozone, India and Australia further raising concerns of another mid-year soft spot in global growth. However, it’s worth noting that PMIs rose in Japan, the UK, Korea and even Greece so it’s not all bad.
  • Moreover, stronger than expected US jobs growth in April and upwards revisions to previous months resulting in average jobs growth of 212,000 over the last three months along with ongoing falls in jobless claims suggest the US labour market is reasonably solid despite January tax hikes and the sequester.
  • The strength in US housing, the fact central banks are easing in the US, Europe & Japan and less acute risks in Europe argue against another mid-year global growth scare on the scale of that seen in the last three years. This won’t necessarily stop investors from worrying but suggests any pull back in shares is likely to be limited to the 5-10% range rather than anything worse particularly as the chase for yield continues to boost high yield shares.
  • In Australia, the focus is back on the budget with the Government announcing a A$12 billion revenue short fall for this year and a 0.5% boost to the Medicare levy to fund a national disability insurance scheme (NDIS). While the revenue shortfall is disappointing and highlights the more difficult environment facing the Australian economy, it is not surprising and is consistent with our own expectation for a A$15 billion deficit this financial year. Moreover it should be borne in mind that the budget deficit will still be much lower than last year’s A$44 billion and the turnaround in the budget deficit from 3% of gross domestic product (GDP) to around 1% this year will still be the fastest turnaround on record (since 1980).
  • The financing of the NDIS has also caused some concern with the increase in the Medicare levy to 2% equivalent to a 0.25% interest rate hike for someone earning $100,000 with a $250,000 mortgage. However, any debate about the financing of the NDIS should not distract from what is, a very worthy initiative.

Major global economic events and implications

  • US data was mostly okay. On the negative side the Institute of Supply Management (ISM) business conditions indices slipped in April and construction spending fell. Against this though consumer confidence rose, personal spending was stronger than expected, house prices and pending home sales rose, payroll employment came in much stronger than expected with upwards revisions to prior months and a further fall in unemployment and jobless claims fell to a five-year low.
  • The US profit reporting season continued to roll on with 405 of S&P 500 companies having reported and 73% coming in better than expected, resulting in profit growth now tracking at +4% versus an expected decline a few weeks ago. Against this only 47% have exceeded sales expectations and guidance has been soft.
  • In Europe, the European Central Bank (ECB) finally cut interest rates taking the official rate to 0.5%. While this is unlikely to have a big impact as the ECB should really be doing something more proactive in terms of pumping cash into the economy like quantitative easing, President Draghi did leave the door open to doing more. Certainly the need for more aggressive easing in Europe is evident in business sentiment indicators falling in April, unemployment rising to a record 12.1% and inflation slumping to just 1.2%.
  • While consternation about Slovenia needing a bailout got a boost by Moody’s decision to downgrade its debt to ‘junk’ status, it’s worth noting that it is another very small economy at just 0.4% of Eurozone GDP. Also, if it were to seek a bailout it would be small at maybe just €3-7 billion, partly reflecting its small banking sector.
  • Japanese economic data was more positive suggesting reflation efforts may be getting traction. Industrial production rose by less than expected but its trend is up and more importantly the manufacturing conditions PMI rose, household spending rose strongly, housing starts are up and the labour market looks stronger.
  • China's official manufacturing PMI confirmed the fall in April reported in the flash HSBC PMI. However, it’s still at a level consistent with 7.5-8% growth in China. While the rise in bird flu deaths in China may have slowed, it’s unclear whether fear regarding it may have adversely affected consumer related activity over the last month.

Australian economic events and implications

  • Australian economic data was disappointingly weak. While new home sales rose in March they are still below January levels and remain low historically. Moreover, the AIG’s manufacturing PMI fell to its lowest since May 2009, its services PMI also fell sharply, credit growth remains very weak, dwelling prices fell in April, albeit after a strong quarter, and building approvals fell 5.5% in March led by a fall in multi-dwelling approvals with private house approvals remaining weak. This all points to the need for another cut in interest rates.

Major market moves

  • Most share markets saw gains over the past week.
  • Commodity prices rose helped, in particular, by the strong US jobs report and this helped push the Australian dollar up slightly despite heightened expectations for another rate cut from the Reserve Bank of Australia (RBA).
  • Bond yields mostly rose on the back of US jobs growth, but fell in Italy and Spain.

What to watch over the next week?

  • In Australia, the big focus will be on the RBA, which hopefully will cut interest rates by another 0.25% on Tuesday. The past month has seen some softer news regarding the global economy, falls in commodity prices and a range of disappointing data in Australia including for various business surveys, building approvals, consumer confidence and job vacancies. So, with the response to the rate cuts of the past 18 months proving to be very tentative and the mining investment slowdown now looming close, it would make sense for the RBA to provide a bit more insurance for the economy by cutting interest rates again. Benign inflation in the March quarter provides it with plenty of scope to do so. Ideally the RBA should cut on Tuesday but it may prefer to get a look at the Budget the week after and March quarter business investment data to be released later in May. So while I expect a cut in the cash rate to a record low of 2.75%, I am agnostic as to whether it’s on Tuesday or next month. The money market also appears to be agnostic with just a 54% chance of a cut priced in for Tuesday.
  • On the data front in Australia, anecdotal evidence points to another rise in retail sales in March (due Monday), ANZ job ads are expected to remain soft (also Monday), house prices are expected to have increased 1.5% in the March quarter (Tuesday) and employment is expected to have increased by 5,000 in April leaving unemployment unchanged at 5.6% (Thursday).
  • Chinese economic data for April will start to flow on Wednesday with growth in exports expected to remain around 10%. Inflation (Thursday) is expected to have remained low at around 2.2% and lending and money supply growth is expected to have slowed from the surge seen in March.

Outlook for markets

  • Shares are at risk of a correction in the next few months, particularly if fears about a global growth soft-patch continue to escalate and given we are now coming into a seasonally weak time of year for shares. However, any set back in shares is likely to be mild (say 5-10% rather than the 15 – 20% falls seen around mid-2010 and mid-2011) and the trend is likely to remain up. Shares are still far from expensive, monetary conditions are very easy, the gradually strengthening global growth outlook led by the US points to stronger profits ahead and investors are likely to increasingly switch from low yielding cash and bonds ensuring solid “buy on the dips” demand. A pick up in mergers, buybacks and dividends from cashed up companies is also likely to be a positive for shares this year. So, notwithstanding usual volatility, this points to a positive backdrop for shares.
  • Sovereign bonds are being helped by Japanese monetary reflation, global growth fears and low inflation. However, they remain fundamentally vulnerable as an improving global, and Australian, growth outlook will likely see bond yields move higher over the year ahead resulting in capital losses for investors in them.
  • The renewed downtrend in commodity prices is acting as an offset to the impact of monetary printing in the US and Japan on the Australian dollar. As a result the Australian dollar looks like remaining stuck in the $US1.02 to $US1.06 range that has prevailed since July last year, with the risks on the downside.

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