Key events of the past week and implications

  • Share markets remain twitchy with a number of ongoing worries, including: the US Federal Reserve (Fed) tapering its quantitative easing program at a time when economic data is mixed; disappointment that Japan's reform program lacks details and will take time; and in Australia, poor growth figures combined with the Reserve Bank of Australia’s (RBA) failure to ease monetary policy again, adding to worries about the economic outlook. From their mid-May highs, Japanese shares have had falls of -18%, Australian shares -9%, Eurozone shares -5% and US shares -3.5%. Global shares in aggregate are down around -5%.
  • The response to recent US data has been schizophrenic. Strong data has been seen as bringing forward Fed tapering and hence as a ‘sell’, and weak data has been seen as bad for growth and hence a ‘sell’ too. The reality is that the mixed US economic data combined with the ‘not too hot, not too cold’ jobs report for May means Fed tapering is still a way off. Probably not until September at the earliest. It won't occur until the Fed regards the US recovery as stronger and selfsustaining at which point profits will be rising more strongly.
  • Investors in Japan have quite clearly moved on from a ‘we trust you’ to ‘show us the improvement’ approach in relation to Japanese policy moves, as evidenced by the negative reaction to Prime Minister Abe's ‘third arrow’ reform plans. The reform plans focusing on deregulating sectors of the economy, boosting exports and reforming the agricultural sector are ambitious and a move in the right direction. But a lack of details contributed to a more cynical response from investors. This likely reflects the market being higher than was the case six months ago. However, our assessment remains that Japan is heading in the right direction and that after the current correction runs its course the share market will resume its rising trend and the yen its falling trend.
  • Australia had a very disappointing week, with first the RBA failing to cut interest rates followed by news that were it not for falling imports and stronger exports Australia would now be in recession. We are now at crunch point for the Australian economy. The mining investment boom is fading rapidly so it’s critically important that non-mining sectors pick up to fill the gap. Increasing home buyer demand is a positive sign in this regard as it will flow on to increased housing construction and retail sales. However, part of the adjustment will require even lower interest rates and a lower Australian dollar. We expect the RBA to cut the cash rate to 2.5% in July or August and to 2.25% around September. We continue to see the Australian dollar falling back to around US$0.80. While our base case is for 2.5% growth this year, it’s also clear that the risks to this are on the downside.

Major global economic events and implications

  • The clear message from US economic data over the last week was that the economy is growing but its hardly booming. The May jobs report saw slightly stronger-than-expected jobs growth of 175,000, but the three-month average of 155,000 is below the Fed’s objective of 200,000 a month, unemployment rose and the average work week was unchanged. In other words, the jobs market is growing but it’s still not the “substantial” improvement the Fed is looking for. While the Institute for Supply Management (ISM) manufacturing conditions index fell to 49 in May, the Markit purchasing managers’ index (PMI) rose slightly to 52.3. But averaging the two still only suggests growth around 2%. The non-manufacturing ISM index rose slightly to 53.7, which is again a long way from boom time conditions and its employment component was softish. Putting it all together suggests the US economy is growing but not at a level to move the majority at the Fed led by Bernanke to start slowing quantitative easing just yet. The Fed may also be a bit concerned that all the talk of tapering has led to a sharp fall in mortgage refinancing as higher bond yields have led to higher mortgage rates.
  • Chinese May data showed: exports and imports much weaker than expected, but after a period of unbelievably strong numbers; growth in retail sales, industrial production and fixed asset investment little changed from April and pretty much as expected; a slowdown in credit growth to be more in line with the growth rate of the economy; and an unexpected fall in inflation to just 2.1%. In fact non-food inflation remained just 1.6%. The basic picture from the latest run of Chinese data is that growth is stuck around 7.5% to 8%, credit growth is coming back under control and inflation is benign. This suggests plenty of scope for monetary easing if required.

Australian economic events and implications

  • The flow of data released over the last week added to the sense of gloom surrounding the Australian economy. Annual gross domestic product growth slowed to 2.5% in the March quarter but with this masking distinct weakness in consumer spending and business investment, retail sales were soft in April, house prices fell in May (although it is dangerous to read too much into monthly house price data given their volatility), job advertisements continued to slide and the Australian Industry Group’s manufacturing conditions PMI remained weak. There were some positives though with company profits up in the March quarter and the household savings rate remaining high at 10.6%, suggesting households have built up a good financial buffer, and the trend in productivity growth remaining solid. But the overall picture is one of softness. Easier monetary conditions are still required.
  • Is cutting interest rates self defeating because it simply takes money from depositors to give to debtors? The short answer is no. Interest rate cuts help household spending in two ways. First, the Australian household sector owes way more to banks (around A$1.7 trillion) than it has in deposits (around A$0.75 trillion), so rate cuts boost the disposable cash flow for households in aggregate. Second, the spending of depositors such as self-funded retirees tends to be far less sensitive to changes in their disposable cash flows than borrowers, particularly young families. On top of this, lower interest rates help by lowering corporate borrowing costs, which should help drive a lower Australian dollar over time and also force investors into more risky assets that helps the flow of funds through the economy. But why is it taking so long to see the benefits this time? There are always long lags in monetary policy but several factors have slowed the impact this time. First, since the global financial crisis, households have become a lot more cautious and so the equilibrium interest rate has fallen. Second and related to this, the RBA was initially too slow to cut rates and in my view it was only late last year they fell into stimulatory territory. Third, the banks did not pass on the full amount of initial rate cuts. Finally, the Australian dollar remained strong. So ultimately I think lower rates will help, but the RBA still needs to do a bit more in the short term.

Major market moves

  • Global share markets remained volatile on worries about US growth and Fed tapering, Japan and China. While US shares rose +0.8%, European shares fell -1.7% and Japanese shares fell -6.5%. Australian shares also fell another -3.8% following the poor global lead and worries about the Australian growth outlook with the continuing slide in the Australian dollar not helping as foreign investors tend to stay away or sell when it is falling.
  • Commodity prices were mixed, partly helped by a weaker US dollar, but this didn’t help the Australian dollar which remained under pressure on weak data and heighted rate cut expectations.

What to watch over the next week?

  • In the US, expect May retail sales (Thursday) to record a modest 0.3% gain, industrial production to rise, consumer sentiment to remain strong and producer price inflation to have remained benign (all due Friday).
  • The Bank of Japan meets on Tuesday but is unlikely to announce further easing given that its current huge reflation program is still working its way through. However, it may reiterate its commitment to achieving stronger growth and inflation and indicate it stands ready to do more in order to help sooth jittery investors.
  • In Australia, housing finance data for April (Tuesday) is likely to slip back a bit after the solid gain seen the month before but leaving in place a rising trend. The National Australia Bank’s business survey (Tuesday) for May is expected to show that both conditions and confidence remain poor with the tough Federal Budget and a run of poor economic news not helping. Similarly, the continuing poor run of bad news including the slide in the Australian dollar is likely to have further depressed consumer confidence (Wednesday). Finally, falling job vacancies and poor employment plans in various business surveys point to a reversal of the unbelievably strong 50,000 jobs gain reported for April. We expect the May labour market report on Thursday to show a 25,000 loss of jobs and a rise in unemployment to 5.7%.

Outlook for markets

  • The correction in shares may have further to go as uncertainty about the Fed, bond yields, Japan and China will linger for a while. However, the correction is likely to be milder 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 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.
  • The falling Australian dollar is likely to remain 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.
  • With commodity prices in a downtrend and the outlook for the Australian economy deteriorating relative to the US, it’s 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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