Key events of the past week and implications

  • The past week saw shares in the US, Europe and Japan rally further and bond yields fall, helped by more dovish comments from US Federal Reserve (Fed) Chairman, Ben Bernanke. Shares were also aided by favourable economic data and earnings results. In fact, the US share market made it to a new record high. However, the Australian share market was basically flat, not helped by falls in the Chinese share market which also weighed on Asian markets generally.
  • The key messages from Bernanke and the Fed remain market friendly: First, while starting to slow quantitative easing later this year is under consideration, this is contingent on the economy improving in line with its forecasts which imply a pickup in growth to a 3% pace during the second half. Second, there is no pre-determined tapering timetable and in fact, the pace of asset purchases could even increase if economic data disappointed. Finally, tapering will not bring forward the timing of interest rate hikes. The bottom line is that US monetary policy will remain extremely accommodative for a while to come and when it starts to become less so, it will only be because the US economy is stronger. Similarly, monetary policy is set to remain easy in Europe, the UK and Japan. This is a supportive message for financial markets.
  • Contrary to fears of a sharper growth slowdown, Chinese gross domestic product (GDP) growth in the June quarter of 7.5% was in line with expectations, with quarterly sequential growth actually picking up a notch. While uncertainty remains about the Chinese Government’s floor for acceptable growth, our assessment is that it’s probably around 7% and to this end, some modest measures to help support growth, such as allowing a weaker Renminbi, will likely be adopted and should be enough to ensure growth of 7 to 7.5% this year. This indicates no fall off the precipice, but no sharp growth rebound either. Continuing strong gains in house prices in June are clearly one factor constraining policy flexibility. Meanwhile, the money market crunch of last month looks to be well and truly over, with overnight interbank lending rates now around 3% and significantly down from highs of around 12%. What’s more, removal of the floor for lending rates announced by the People’s Bank of China is a move in the right direction in terms of interest rate liberalisation. However, as not much lending occurs below the current floor anyway, it’s hard to see it having much economic impact.
  • Meanwhile, the Reserve Bank of India announced a tightening in liquidity conditions to help support the falling Indian rupee. Coming on the back of uncertainty regarding China and rate hikes in Brazil and Indonesia, it clearly adds to the uncertainty hanging over emerging markets at present. Expect developed country shares to continue outperforming the emerging world.

Major global economic events and implications

  • US economic data was mostly positive. Retail sales rose by less than expected in June and housing starts fell sharply. However, the fall in housing starts was largely driven by the volatile multi-dwelling category and a continuing sharp rise in home builders’ conditions suggests that housing starts will resume their rising trend. Meanwhile, industrial production rose solidly in June, weekly jobless claims fell sharply and manufacturing conditions improved in the New York and Philadelphia regions.
  • It is early days yet for the June quarter earnings reporting season, with 103 S&P 500 companies having reported so far, but it seems off to a solid start with 73% having exceeded earnings expectations and 53% having exceeded revenue expectations. The overall impression remains that the US corporate sector is in good shape.
  • Continuing improvement in the US public debt situation was highlighted by Moody’s moving the outlook for its AAA sovereign rating for the US to stable from negative on the back of the declining US budget deficit – which is now running at around 4.6% of GDP compared to a high of 10.4% in 2010.
  • In Europe, core inflation remained benign at just 1.2% over the year to June. The European Central Bank’s (ECB) easing of collateral rules for banks to borrow from it may aid lending for small business, but it’s unclear how significant the impact will be.

Australian economic events and implications

  • In Australia, the minutes from the Reserve Bank of Australia’s (RBA) last Board meeting maintained an easing bias, but with the RBA explicitly noting the fall in the A$ and the monetary stimulus already in place, the easing bias seems to have weakened a notch. That said, since the last meeting we have seen weaker data for retail sales and business conditions with rising unemployment and as such, barring a further sharp fall in the value of the A$, we remain of the view that the RBA is on track to cut the cash rate further.
  • While the move to an emissions trading scheme a year earlier than scheduled will benefit households and cut around 0.5% from inflation, it’s hard to see much impact on growth overall, given the offsetting reductions in industry assistance and other savings such as tighter arrangements regarding fringe benefit tax for cars. The RBA is likely to look through any impact on inflation just as it did with the commencement of the fixed price on carbon.
  • It was a quiet week on the data front in Australia, with falls in housing starts and imports. However, the rising trend in building approvals suggests that the fall in housing starts will be short lived.

Major market moves

  • Developed country share markets saw good gains over the last week helped by soothing comments from Ben Bernanke and good US earnings results. US shares rose 0.7%, Eurozone shares gained 1.5% and Japanese shares rose 0.8%. However, Australian shares were flat and Chinese shares fell 3.7%.
  • Commodity prices and the A$ rose, helped by a generalised fall in the US$ on the back of Ben Bernanke’s dovish comments.
  • Bond yields fell marginally as fears of an earlier rate hike in the US continue to fade.

What to watch over the next week?

  • In the US, expect the housing recovery to be confirmed by a continuing rising trend in existing and new home sales (due Monday and Wednesday, respectively) and in house prices (Tuesday). The Markit preliminary manufacturing conditions PMI for June (Wednesday) is expected to have remained near its recent level and durable goods orders (Thursday) are expected to show further gains in underlying terms.
  • In the Eurozone, focus will be on preliminary business conditions PMIs (Wednesday) which are expected to continue the rising trend evident in recent months. The German IFO business conditions index will be released on Thursday.
  • Japan is likely to see a pick-up in the pace of economic reforms after the governing LDP won control of the upper house in weekend elections. Japanese inflation data due on Friday is expected to show a further moderation in deflation.
  • China's HSBC flash PMI will also be released Wednesday and is likely to have remained soft.
  • In Australia, June quarter inflation data to be released Wednesday are expected to show that inflation remains benign, which will likely set the scene for another cut by the RBA when it meets in early August. While solid gains are expected in prices for fresh fruit and vegetables and health, this is likely to have been offset by continuing poor pricing power as clearly evident in the NAB’s business survey, resulting in a rise in the consumer price index of 0.5% in the quarter and 2.5% year-on-year. The average of the underlying inflation measures is also expected to have increased by 0.5% in the quarter, resulting in a 2.3% yearly change. With both measures running around or just below the mid-point of the RBA's inflation target, inflation is not a barrier to further monetary easing.

Outlook for markets

  • We are still in a seasonally weak period of the year for shares and worries about the Fed tapering its monetary stimulus, approaching US debt ceiling negotiations, growth in China and the growth slowdown in Australia have the potential to cause more volatility. However, the broad trend in shares is likely to remain up, given that valuations are still reasonable; monetary conditions are likely to remain very easy with interest rate hikes a long way off in all developed countries and rates still likely to fall further in Australia; and the gradually strengthening global growth outlook points to stronger profits ahead. So by the year’s end we see further upside in global and Australian shares.
  • Although bond yields have moved up too far too fast lately given the outlook for short term interest rates and are due for a pause, sovereign bond yields still remain low and point to low medium-term returns.
  • Very large speculative short positions continue to provide some support for the A$ in the short term, but with commodity prices in a downtrend and the outlook for the Australian economy deteriorating relative to the US, it’s likely the A$ will ultimately resume its downswing. Given its overvaluation in terms of relative prices, expect the A$ to head towards US$0.80 over the next few years.

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.