Key events of the past week and implications

  • It was another volatile and poor week for investment markets with the confirmation that the US Federal Reserve (Fed) is on track to start slowing the pace of quantitative easing (QE) later this year, triggering a renewed bout of weakness in shares, bonds, commodities and the Australian dollar which was then added to by more bad news from China.
  • From their mid-May highs to recent lows, Japanese shares have had falls of 20%, Australian shares -10%, Eurozone shares -9% and US shares -5%. Global shares in aggregate have corrected by around 7%.
  • While the message from the Fed was taken badly, our interpretation is that it was actually quite supportive. Fed Chairman Bernanke certainly seemed a bit more strident in signalling that the Fed was on track to taper the current quantitative easing program from later this year and in noting that if things go to plan it will be phased down to zero by mid next year. And it was this that the markets took their lead from, with shares falling and bond yields rising sharply. However, the bulk of the Fed’s message was actually very supportive for investment markets in that QE will only be phased down and eventually stopped if growth continues to improve as it forecasts and that interest rates are unlikely to be increased until 2015 at the earliest. The former means that either growth and profits improve or QE continues, which is a positive message for shares and the latter should be positive for bonds. More broadly, the fact that the Fed is even thinking about this is very positive as it means the US can be taken off life support. But as always, when a patient is taken off life support it can lead to uncertainty as to whether there might be a relapse and that is partly what investors seem worried about.
  • Signs that Ben Bernanke may step down in January may have also added to the nervous reaction, but it’s worth noting his replacement will likely be someone with the same approach such as Fed Governor, Janet Yellen.
  • The other big issue though is that the back-up in bond yields has partly taken on a life of its own reflecting an unwinding of extreme “long” positions after the massive bond rally of recent years led to, and was spurred on by record inflows into bond funds. US bond funds are now seeing this go into reverse with huge outflows - in fact a record US$17 billion in outflows over the last three weeks. Following the losses on bonds seen in May, this in turn is helping drive bond yields even higher. At some point in the months ahead, the back-up in bond yields will be limited as short term interest rates remain low, but in the very near term the rush for the exits by bond investors could have further to go, causing further increases in yields.
  • Chinese news remained poor, with another fall in HSBC’s flash manufacturing conditions PMI suggesting that growth may be slowing to around 7%. Adding to the worries about China was a sharp spike in interbank lending rates. The failure of the Peoples Bank of China (PBOC) to quickly inject liquidity suggests it reflects a desire to force banks to rein in excessive lending via the higher risk “shadow banking” system. While this is desirable from a longer term perspective, the risks to Chinese growth falling below our expectation for 7.5% this year are growing.
  • The global backdrop presents a confusing picture for Australia. Uncertainty regarding China is bad news, but the Fed's progress towards reducing QE is good news as it means less support for the A$, which was reflected in a decisive break in the A$ below the low end of the range it has been over the past two years. This is good news as a stubbornly strong A$ has been a key factor explaining why the economy has been slow to respond to lower interest rates. The A$ has now fallen 11% from its average level of the last year. With roughly 30% of share market earnings sourced offshore, this roughly means a 3.3 percentage point boost to earnings growth over the year ahead. This is before the boost from improved competitiveness is allowed for. So if the A$ remains here or falls further, expect to see earnings upgrades for foreign earners over the next few months.
  • The recent turbulence in markets may have further to go as uncertainty about the Fed and China and the unwinding of long bond positions will take a while to dissipate. However, we remain of the view that it’s just a correction and that markets will resume their uptrend as it becomes clear that the global economy is continuing to gradually improve, that the Fed will only wind down its monetary stimulus if the US economy accelerates and as it becomes clear that US and global interest rates will remain low.

Major global economic events and implications

  • In the US, housing starts rose by less than expected, but a rise in a home builders conditions index along with a rising trend in permits to build new homes and a strong increase in existing home sales point to further gains ahead. Manufacturing conditions indices painted a mixed picture with the national Markit PMI little changed from May, the details of a New York regional survey looking pretty weak, but manufacturing in the Philadelphia region is looking strong. Unemployment claims actually rose and the threat posed by rising bond yields flowing into rising mortgage rates was highlighted by a fall in mortgage applications. Meanwhile, inflation data remained benign. Overall, the US economy still looks to be growing around a 2-2.5% pace.
  • In the Eurozone, manufacturing and services conditions PMIs were all stronger than expected, continuing the rising trend that has become evident since late last year. Consumer sentiment also improved sharply. This adds to confidence that the Eurozone recession is abating. However, Greece was back in the headlines with a member of the coalition Government leaving in a dispute over the national broadcaster. This aside, the Government retains a parliamentary majority so it's not as threatening as last year's Greek crisis.

Australian economic events and implications

  • In Australia it was a quiet week on the data front, with the Westpac Leading Index rising solidly but with falls in vehicle sales and skilled vacancies. The Australian Bureau of Statistics (ABS) also released a quarterly labour market report showing where jobs growth has been. Over the year to May the star performers have been retail, health, accommodation and government, whereas sectors such as finance, mining and manufacturing have gone backwards.
  • Meanwhile, the minutes from the Reserve Bank of Australia’s (RBA) last Board meeting confirmed that it retains an easing bias and consistent with this, signalled uncertainty about the strength of non-mining investment in the face of a peak in mining investment and also indicated that the A$ remained "high". Our assessment remains that the RBA will have to cut interest rates again, but obviously if the A$ keeps falling it will reduce the amount by which the RBA will have to cut.

Major market moves

  • Share markets saw further falls on the back of the Fed's comments about tapering and worries about China. Japanese shares were the exception though, managing strong gains after earlier sharp falls.
  • The falls in share markets also flowed through to commodities, with the gold price falling to its lowest since 2010.
  • The combination of a more upbeat Fed saw the US$ rise and this along with China worries saw the A$ resume its downswing.
  • Bond yields continued to surge in response to the talk of QE tapering from the Fed. High and rising bond yields make this year's bout of share market weakness very different to that of the last three years when fears of a "double dip" recession in the US led bond yields to fall.

What to watch over the next week?

  • In the US, expect to see a continued rising trend in durable goods orders, further solid gains in house prices for April and in May new home sales, a slight fall in consumer confidence (all Tuesday) and another rise in pending home sales (Thursday). Data for personal income and spending will also be released Thursday.
  • In the Eurozone, business confidence indicators will be watched to see whether they continue the improving trend evident in business conditions PMIs for June.
  • Japanese data due on Friday are expected to show further gains in household spending, industrial production, manufacturing conditions and the labour market, along with a further slowing in deflation.
  • In Australia, expect data for job vacancies (Thursday) to remain weak and credit growth (Friday) to remain soft.

Outlook for markets

  • It's too early to say that the falls in shares are over, however we remain of the view that it's just a correction and that the broad cyclical trend remains up. Shares are far from expensive, monetary conditions are likely to remain very easy with interest rate hikes a long way off and the gradually strengthening global growth outlook points to stronger profits ahead. So by year end, we see further upside in global and Australian shares.
  • While Australian shares remain vulnerable in the short term as uncertainty about the Australian economic outlook continues, they are expected to benefit by year end from low interest rates boosting high yield stocks and the combination of lower interest rates and a lower A$ driving improved profit expectations.
  • Although bond yields have moved up too far too fast lately given the outlook for short term interest rates, sovereign bond yields still remain low and point to low medium term returns.
  • Very large speculative short positions hold out the prospect of a near term bounce in the value of the A$, but with commodity prices in a downtrend and the outlook for the Australian economy deteriorating relative to the US, it's likely that the A$ is ultimately headed lower. Given its overvaluation in terms of relative prices, expect the A$ to head towards $US0.80 over the next few years.

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