Key events of the past week and implications

  • Investment markets remained jittery over the last week as nervousness continued about the US Federal Reserve (Fed) slowing the pace of stimulus, as bond yields continued to rise with some fearing a 1994-style bond crash and as expensive defensive high yield shares continued to correct in Australia not helped by foreign investors selling down their yield plays as uncertainty remained about the Australian dollar. From their mid-May highs, Japanese shares have had a fall of 13%, Australian shares -5.6%, Eurozone shares -2.4% and US shares -2.3%. Japanese shares have been hit the hardest because they had a massive 80% gain since November lows.
  • The share market correction could still have further to go as it normally takes a while for the dust to settle, but it is worth noting that the global volatility of the last few weeks has a radically different feel to that seen in each of the last three years. This time around there hasn’t been a peep out of Europe and more importantly bond yields have gone up rather than down. At its core, its about the Fed getting close to achieving its aim of getting the US economy back on to a stronger footing and in turn trying to judge when the US economy can start to be taken off life support and what this will mean in terms of bond yields and high yield share plays that have benefited from low bond yields. This can and will cause volatility. But it’s a far better problem to have than the risk of a return to global recession that has hung over investors in the past few years. As a result we remain of the view that recent volatility is a correction that will give way to a resumption of the rising trend in share markets. My year-end target for the Australian share market (ASX 200) remains 5250.
  • Will there be a 1994-style bond crash? The year ahead will likely see poor returns from government bonds as yields drift higher, but a sharp back-up in yields leading to big losses for bond investors is possible but unlikely just yet. While the US and global economy is looking better, growth is still a long way from booming, spare capacity remains immense, bank lending is still subdued and inflation is low. So it is very hard to see central banks led by the Fed raising interest rates anytime soon and as such the extent to which bond yields will rise will be limited. This is particularly the case in Australia where the debate is still about how low the cash rate will go.

Major global economic events and implications

  • US economic data was mostly positive with another increase in house prices, a rise in weekly mortgage applications and pending home sales leaving in place a rising trend for both, gains in consumer confidence to pre-global financial crisis levels and improved manufacturing conditions in May according to several regional surveys. While personal spending fell in April, a larger fall in inflation meant that it actually rose in real terms. The Fed’s preferred measure of core inflation is now running at just 1.1% year-on-year.
  • Eurozone business and consumer confidence measures rose consistent with the gains seen in May purchasing managers’ indices (PMIs).
  • Japanese data provided evidence Abenomics is working with gains in household spending, industrial production, a manufacturing PMI and the job-to-applicant ratio. Even the pace of deflation appears to be easing.
  • There was some good news from China with the official May PMI rising contrary to expectations and leaving in place a mild rising trend since August last year that suggests at least stable growth.
  • Korean industrial production and exports also unexpectedly rose.

Australian economic events and implications

  • The news on business investment in Australia wasn’t good. March quarter capital expenditure fell 4.7% with mining investment looking like it peaked last year and other sectors remaining weak. While the investment intentions for the year ahead look okay if viewed using comparisons of past outcomes to intentions (or realisation ratios), our concern is that they are overstated by resource project cost blowouts and that against the background of current uncertainty realisation ratios will be much lower than normal. Given this concern a better approach is to compare the latest estimate for the year ahead with the corresponding estimate made a year ago and that suggests a 9.8% fall investment over the next financial year. Consistent with the capital expenditure data, construction activity was weak in the March quarter, particularly engineering construction. Private credit growth also remained subdued in April at just 3.1% annually, although housing credit growth flicked up from a record low of 4.4% year-on-year, but only to 4.5%.
  • However, it wasn’t all doom and gloom. New home sales rose 4% for the second month in a row, housing affordability is at its highest since March 2009, and building approvals rose 9% in April and are in a gradual rising trend. So interest rate cuts do seem to be getting traction in the most interest sensitive part of the economy.

Major market moves

  • Share markets mostly fell over the past week on the back of nervousness about Fed tapering and the impact of rising bond yields.
  • Bond yields rose further, not helped by Fed quantitative easing tapering fears on the back of better economic data.
  • Commodity prices were mostly lower, including the iron ore price which looks like its heading lower until the steel glut in China is resolved. The Australian dollar remained under pressure.

What to watch over the next week?

  • In the US, the Institute for Supply Management (ISM) manufacturing conditions index (Monday) and the May payroll report (Friday) will take on greater-than-normal significance given the debate about when the Fed will start to slow the pace of quantitative easing. However, neither are likely to bring the Fed any closer to tapering. The ISM is expected to rise only slightly from its April reading of 50.7 and payroll employment is expected to expand by 175,000, which is below the 200,000 monthly average the Fed would prefer. Data for the trade balance (Tuesday) and the ISM non-manufacturing conditions index (Wednesday) along with the Fed's Beige Book will also be released.
  • The European Central Bank (Thursday) will probably do nothing, but the tone will remain dovish with further easing expected over the next few months. On the data front, final business conditions PMIs (due Monday and Wednesday) for May are expected to confirm the slight improvement reported in the preliminary releases.
  • Chinese economic activity and inflation data for May will be released over the weekend (8 and 9 June) and is expected to show a slight improvement in the pace of growth in retail sales and industrial production and that inflation remains benign at around 2.4%.
  • In Australia, the focus will return to the Reserve Bank which we expect to announce another 0.25% rate cut taking the cash rate to a new record low of 2.5%. I must say though it’s another close call, as the Reserve Bank of Australia (RBA) may decide that having cut in May and with the fall in the Australian dollar it will wait and assess for now. Against this though, the Australian dollar hasn't really fallen enough to provide a big stimulus to the economy (its just at the low end of the range its been in for two years), the latest business investment readings confirm that mining investment has peaked and that nonmining investment is likely to remain weak, readings for business and consumer confidence have been poor, forward-looking jobs indicators are soft and the toughish Budget and Ford's decision to quit manufacturing seem to have added to the sense of gloom surrounding the Australian economy. As a result, with low inflation providing plenty of scope to ease the RBA should act again on its easing bias and on balance we think that it will.
  • On the data front in Australia, it will be the usual deluge seen when the Australian Bureau of Statistics releases quarterly gross domestic product (GDP) data. On Monday, data for retail sales is expected to show a modest +0.3% gain but quarterly data for profits and the Australian Industry Group's manufacturing PMI are expected to remain soft. On Tuesday data for net exports is expected to show a positive contribution to March quarter GDP growth but public final demand is likely to have fallen. March quarter GDP data on Wednesday is expected to reveal growth of +0.5% or +2.4% year-on-year with strength in consumer spending and net exports offset by weakness in business investment.

Outlook for markets

  • The correction in shares may have further to go as uncertainty about the Fed, bond yields and China will linger for a while. However, the correction is likely to 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 likely to remain very easy with interest rate hikes a long way off, the gradually strengthening global growth outlook points to stronger profits ahead and the desire for better returns than bonds and cash can provide will likely see ‘buy on the dips’ demand from investors. So by year-end we see further upside in global and Australian shares.
  • The falling Australian dollar is 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.
  • While a bond crash is unlikely at this stage, 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.
  • The Australian dollar appears to be finding some support around US$0.95/0.96 which is the low end of its range for the last two years, but with commodity prices in a downtrend and the outlook for the Australian economy deteriorating relative to the US, its likely the Australian dollar is ultimately headed much lower. Given its overvaluation in terms of relative prices and costs, expect the Australian dollar to head towards US$0.80 over the next few years.

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